Screening and Signalling in Debt Strategies: Theory and Empirics

This thesis focuses on public debt under asymmetry of information. The first part of the thesis deals with foreign debt while the second part with domestic debt. In the first part of this work (Chapter 1 and 2) a theoretical model is developed in which adoption of an IMF programme signals a country's productivity. It is assumed that there are two types of country, one with a high return on investment and the other with a low return. The country's type is known only to itself. In the presence of a debt overhang, the high productivity country may choose not to undertake the investment, despite it being socially efficient to do so. In this case the creditor would like to offer the country some debt reduction, but the low productivity type will also benefit from the debt reduction. This problem can be avoided if the country has sufficient resources to engage in a debt buyback in order to gain the debt relief: only the high productivity type would be prepared to sacrifice current resources for the debt reduction, and thus a separation of the two types is achieved. (This is similar to an argument found in Acharya and Diwan, 1993). We argue, however, that it is unlikely that a heavily indebted country will have sufficient resources for a buyback. If the country is credit constrained, an alternative screening mechanism is to undertake an IMF programme in return for debt reduction and possibly an IMF loan. This mechanism can be the equilibrium outcome even if the programme creates only disutility for the country's policy makers. The existence of an empirical relationship between the adoption of an IMF programme and the concession of a debt rescheduling by commercial and official creditors is tested in Chapter 3 using a bivariate probit model (to control for the endogeneity of the choice "IMF adoption"). If countries who have arrangements with the IMF are more likely than others to obtain a rescheduling of their external debt we could conclude that the adoption of an IMF programme could work as a sort of signal of a country's "good intent", which is thus rewarded with the debt relief. The results confirm the existence of a significant effect of the adoption of an IMF programme on the subsequent concession of a debt rescheduling by creditors. In the second part of the thesis we have investigated some of the consequences due to the existence of a large public debt (as it is the case in some of the European countries, e.g., Belgium, Greece, Ireland and Italy). More specifically, a theoretical model is developed, in Chapter 4, to examine whether buybacks of domestic debt may signal a government type. In the model it is assumed that the government could be of two types: a dry type and a wet type, according to its willingness to implement a fiscal stabilisation (in this model this basically means reducing fiscal spending). Asymmetry of information between the government and private investors is assumed. In particular interest rates are assumed to incorporate a risk premium which reflect the expectation that the inability to implement a stabilisation programme may result in more inflation and/or taxation, or debt default. In particular, during a fiscal stabilisation, private investors would lack confidence in the stabilisation programme and interest rates would be too high, reflecting this lack of credibility. Thus, a dry type who has to finance new spending may want to signal her resolution in order to lower the interest costs and one way to do that would be to repurchase a fraction of the outstanding debt. The wet type could also decide to buy-back some of his debt in order to pretend to be dry and to (possibly) lower his interest payments. It is showed that a critical amount of buyback exists such that the two types could be separated. Finally, in Chapter 5, evidence is provided in favour of the hypothesis that the repurchase of public debt is actually perceived as a good signal by private investors, consistently with the theoretical model. According to our results, the initial impact of the repurchase was to make the prices of the remaining bonds rise. This was consistent with our theory as we can interpret an increase in bonds price (and correspondingly a decrease in their rates of returns) as a signal that the buyback operation has positively affected the credibility of a government.