USING AUCTIONS TO ALLOCATE AND PRICE LONG-TERM CREDIT

Most long-term credit in developing countries is allocated through neg otiated agreements between government institutions and financial inter mediaries or final borrowers, and often at administered rates. Yet man y developing countries have no long-term credit market whose interest rates can be used as benchmarks for these loans. If credit is priced i mproperly, it will be allocated inefficiently and the development of c apital markets may be stunted. In light of the generally disappointing experience with conventional methods of allocating development credit , some countries have introduced credit auctions as an alternative. Am ong the advantages are greater transparency and fairness, lower transa ction costs, and increased competition and efficiency. Among the disad vantages are a greater vulnerability to collusion, which can lead to l ower interest rates and revenue, and a tendency to attract the least d esirable participants (adverse selection) and to lend for riskier proj ects (moral hazard), which can lead to lower repayment rates and a hig her probability of default. All these factors can lead to inefficiency in the allocation of funds. This article suggests ways to lessen thes e negative effects and presents various elements of auction design tha t affect the efficiency of credit auctions and their suitability to sp ecific circumstances. When properly designed, auctions can be used in a variety of environments to allocate development credit more efficien tly than current methods do.