Donor herding and domestic debt crisis

Abstract

This article presents a new model based on the loan-pushing model by Basu (1991) to show how a domestic debt crisis can occur in a low-income country following donor herding. The model focuses on the rational herding behaviour of donors due to payoff and information externalities. Although there are many theoretical models on herding behaviour, these models have not formally considered the relationship between donor herding and domestic debt crisis in a low-income country. This article is an attempt to fill this gap. The article shows that due to donor herding behaviour a domestic debt crisis can occur once the actual debt level is above the desirable one.

Acknowledgement

The authors would like to thank, without implication, Robert Flood and Paul Cashin for stimulating discussions and useful suggestions, as well as Peter Fallon, Carlos Leite, and David O. Robinson for comments and suggestions.

Notes

¹ Basu (1991) observes that the interest rate is not the only factor involved; debt maturity and default provisions are also important.

² This is a corner solution. In practice, there may be a minimum level of donor inflows, for example, in the form of humanitarian aid. However, the results obtained in this case would not be qualitatively different from what follows in the rest of the article.

³ A possible reason could be that the LIC government believes that donors will be faced with the ‘Good Samaritan's’ dilemma, and not walk away for a prolonged period.