We analyze relational contracts between a lender and borrower when borrower cash  ows are not contractible and the costs of intermediation vary over time. Because lenders provide repayment incentives to borrowers through the con- tinuation value of the lending relationship, borrowers will condition loan repay- ment on the likelihood of receiving loans in the future. Therefore, the borrower's beliefs about the lender's future liquidity and profitability become an important component of the borrower's repayment decision. Consequently, the possibility of high lending costs in the future weakens repayment incentives and can cause the borrower to strategically default in some states and an inecient under-provision of credit. We characterize the optimal relational contract and discuss the appli- cation of our model to the case of microfinance and trade credit.