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 cred-ible signaling channel between a sovereign government and foreign creditors. The govern-ment has private information regarding the future economy. The one with a good eco-nomic 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 signaling equilibrium demonstrating the feature that a more precise signal of good economic outlook leads to a greater extent of fiscal austerity. As the information be-comes more precise, the signaling cost for a government with a good economic outlook increases. Interestingly, unless the prior is very pessimistic, a highly precise signal harms the sovereign because a resulting strong signaling motive drives it to reduce bond issuance excessively (paradox of highly precise information).(c) 2022 Elsevier B.V. All rights reserved.