Private Capital Flows and Default Risk
What has been the effect of the shift in emerging market capital flows toward private sector borrowers? Are emerging markets capital flows more efficient? If not, can government intervention improve welfare? This paper shows that the answers to these questions depend upon the form of default risk. When private loans are enforceable, but there is the risk of national default, constrained efficient capital flows can be decentralized with private borrowing subject to individual borrowing constraints. However, when private agents may individually default, private lending is always inefficient, and borrowing subsidies are potentially Pareto-improving.