Signalling Creditworthiness with Fiscal Austerity

Abstract

Sovereign borrowers may tighten their fiscal stance in order to signal their creditworthiness to lenders. In a model of sovereign debt with incomplete information, I show that a trustworthy country may reduce its debt beyond the optimal level in order to separate itself from less reliable countries. Since austerity is costly, the gains in the price of debt from separating need to be high enough, as is the case when credit ratings provide very noisy signals. I proxy for the informativeness of the ratings with two model-implied variables and find empirical support for the existence of a signalling channel.