Defaults and interest rates in international lending

Since lenders cannot observe the riskiness of the projects that borrowers could choose, interest rates alone cannot be used as an instrument to discipline borrowers. A credible threat to exclude borrowers who default more than a certain number of times from participating in the capital markets makes international debt contracts incentive compatible. Since larger borrowers get fewer chances to default, they choose safer projects and are therefore charged lower interest rates. Also, borrowers, after each successive default, switch to safer and safer projects, which may result in lower and lower interest rates. This paper provides empirical evidence supporting these two predictions.