This paper assesses the impact of information asymmetries between lenders and borrowers in developing country external financing and considers alternative techniques to reduce the adverse implications of such asymmetries. Information asymmetries arise when lenders cannot fully observe or verify borrowers’ actions.
The second section of the paper examines the role of information in financial markets and analyzes the incentives to borrowers provided by alternative financial contracts and the risk-sharing properties of these contracts, particularly of state contingent (equity-type) contracts. It shows in a simple framework that in the presence of asymmetric information between lenders and borrowers, there is an inevitable trade-off between efficient risk sharing and incentive provision. It also argues that information asymmetries that are present in domestic finance are more prevalent in international finance, in particular in developing country external financing.
The third section reviews measures designed to resolve information asymmetries, including regulations and policies in borrowing and creditor countries, as well as innovative contractual agreements. However, despite the contribution of these measures, residual problems remain unresolved. Additional measures are suggested, including the enhancement of investment incentives within a conducive macroeconomic environment, which could be achieved through sound economic policies, and the improvement of the flow of information by establishing a set of regulations for channeling information.
International financial institutions, especially the IMF, are in a unique position through their relations with member countries to help alleviate some information asymmetries. By facilitating the design and monitoring the implementation of solid economic policies, the international financial institutions contribute to the resolution of problems associated with the overall macroeconomic environment. Furthermore, in the context of their catalytic role, these institutions can contribute to the sustain-ability of other capital flows.