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.