Incentives in allocation of policy loans

Based on the principal-agent framework I develop a simple model of policy l oans, which are granted by the government on non-market terms, to formalize this important banking phenomenon in both China and other developing count ries. A supply constraint is imposed on the credit allocation process. The incentive compatibility constraints for the implementation of any lending p olicy with favoritism are related to different observabilities of outputs. The social planner's optimal credit policy is derived as a function of exte rnalities and available funds. Our result shows that favoritism should be i mplemented to a less extent as the supply of credit decreases, no matter ho w large the externality is. (C) 2000 Elsevier Science B.V. All rights reser ved. JEL classification: P31; P34.