Abstract

This paper analyzes the effect of political instability on net capital outflow, debt accumulation, and the welfare of a sovereign borrower. Political instability is proxied by the sovereign’s impatience. The loan contract is constrained by two frictions characteristic to international lending: 1) moral hazard where the lender cannot observe whether the borrower efficiently uses the loan and 2) risk of repudiation. I show that a politically unstable country achieves higher utility, borrows more and experiences less capital outflow than a patient borrower. The difference in the borrower and the lender discount factors allows for an intertemporal trade in payoffs that benefits the borrower.