International Financial Assistance: A Loan Mechanism-Design Approach

International Financial Institutions (IFIs) tie resource transfers to capital-scarce countries to improvements in their economic policies and institutions. The objective of this assistance is twofold: to augment the recipient's capital base and to improve its allocation of resources. This paper offers a political-economy explanation for the limited success of some of these loan programs. In our model, governments select policies under the influence of interest groups. Their capacity to absorb IFI loans and their reform efforts are both unobservable to the IFI. An optimally designed loan mechanism must create sufficient incentives in the form of rewards and punishments to counter the influence of interest groups on economic policy choices. The loan mechanism is, however, constrained in two ways: it cannot punish a country so severely as to threaten its political stability and it must remain affordable to the IFI. Whenever reform incentives are inadequate, a government will accept the loan but cheat on the implementation of reforms. If, on the other hand, the mechanism design is optimal, it might be so costly to the IFI that a well-entrenched interest group can block the reform program. Nonetheless, the availability of properly designed loan mechanisms will push governments to implement partial reforms even if the optimal mechanism is too costly for the IFI.