Charles R. Frank

Optimal Terms of Foreign Assistance

As debt service payments of the less-developed world increase very rapidly, an increasing number of writers warn that the terms of foreign assistance must be softened or a large number of less-developed countries will find the burden of their debt service intolerable (see, for example, the Organization for Economic Cooperation and Development [1968]). On the other hand, the writings of a number of economists have provided arguments for the use of relatively high rates of interest, at least as high as the government borrowing rate in the donor country (see Schmidt [1964] and Cooper [1965]). The purpose of this paper is to analyze optimal terms of foreign assistance under three different types of assumptions: (1) perfect certainty and a constant return to capital, (2) limitations on absorptive capacity of the borrowing country, and (3) uncertainty of returns in the borrowing country. These three cases lead to quite different lending criteria.