Sovereign Default and Private Government Information

This paper develops a model of sovereign debt in which the government has some private information about the domestic economy. Sovereign borrowing is sustainable without enforcement, as repayment is a costly signal about the hidden economic fundamental. The signaling mechanism is able to jointly explain three empirical observations: (1) sovereign defaults usually happen in bad macroeconomic conditions, (2) foreign credit to the private sector contracts after the government defaults and expands after subsequent improvements in sovereign ratings, and (3) the current accounts and interest rates are usually counter-cyclical, especially in emerging markets. Furthermore the model reveals a novel positive externality of precautionary savings on the sustainability of sovereign debt. It also predicts that domestic agents, if left on their own, will under-insure against the risk of sovereign defaults. A numerical exercise shows that the information channel can explain a nontrivial level of sovereign borrowing. Overall, the paper argues that private government information plays an important role in understanding a country's ability to borrow from abroad.