A model of sovereign debt with private information

This paper develops a sovereign debt model with investment, in which the country’s productivity shock has two components: a private shock (such as a change in domestic institutions) and a public shock (such as a publicly observed technological change). The government observes the private shock, but foreign investors do not. The government then uses debt repayment and default settlement as costly signals of the private shock. The signaling mechanism generates an endogenous cost of default. Furthermore, the combination of the public shock and the private shock loosens the relationship between default cycles and output in equilibrium: defaults can happen when output is above trend, and settlements can happen when output is below trend, as seen in data. The model also predicts a correlation between default cycles and foreign investment, as well as countercyclical sovereign spreads and trade balance, which are consistent with data.