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Optimality of bailout lending when asymmetric information increases sovereign yields
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Resumo(s)
Is the sovereign debt market information-sensitive to the true borrowing amount? If yes, does asymmetric information affect welfare? What mechanism can improve the welfare of transparent governments? To address these questions, this paper builds a sovereign debt model in which the government can be transparent or opaque. The model predicts that asymmetric information about the government’s type decreases the welfare of a transparent government, by either inducing a transfer of welfare to an opaque government through the market price or by leading to market breakdown. Building on this model, I develop a mechanism of inspection and penalties on cheating governments and conclude that bailout lending when market yields rise as a result of this information friction does not necessarily improve the welfare of transparent governments compared to market lending, if the market still provides lending.