Effects of Information Quality on Signaling through Sovereign Debt Issuance

This paper develops a sovereign debt model proposing that a debt issuance can be a credible signalling channel between a sovereign government and foreign creditors. The government has private information regarding the future economy. The one with a good economic outlook would like to find a credible way to disclose it to obtain a high bond price. Foreign creditors are interested in inferring the government’s private information to assess sovereign default risk precisely. The government’s private information is imperfect, so the precision of information matters. We study how the interaction of the prior, the signal, and its precision affects the equilibrium and the resulting welfare. We propose a unique separating equilibrium where a government with a good economic outlook issues a smaller amount of bonds, even though its default risk is low, than one with a bad economic outlook. As the information becomes more precise, the signalling cost for a government with a good economic outlook increases. Interestingly, unless the prior is very pessimistic, a highly precise signal harms it, because a resulting strong signalling motive drives it to reduce bond issuance excessively (paradox of highly precise information).