where _E_ denotes the expectation operator of domestic agents, _β_ denotes the subjective discount factor, and _ct_ represents consumption. The utility function is strictly increasing and concave. The government cannot commit to future (default and borrowing) decisions.<sup>24</sup> The economy’s endowment of the single tradable good is denoted by _y ∈ Y ⊂_ R++. This endowment follows a Markov process.

**Market debt.** The small open economy borrows from a large pool of international investors by issuing long-duration bonds, _b_ . As in Hatchondo and Martinez (2009), a bond issued in period _t_ promises an infinite stream of coupons that decreases at a constant rate _δ_ .<sup>25</sup> In particular, a bond issued in period _t_ promises to pay _κ_ (1 _− δ_ )<sup>_j−_1</sup> units of the tradable good in period _t_ + _j_ , for all _j ≥_ 1. The advantage of this payment structure is that it enables us to condense all future payment obligations derived from past debt issuances into a one-dimensional state variable: the payment obligations that mature in the current period.

**Hidden debt.** We assume that in addition to market debt, the country also faces an exogenous process for hidden debt. Provided that there has not been a revelation in the previous period (more details on the revelation below), the country starts period _t_ with a level of hidden debt, _h_ , which has the same coupon structure as the market debt. Absent a default in period _t_ , the country needs to service the initial hidden debt (i.e., it pays the coupons due), and it draws a “hidden-debt issuance” realization _ε_ from a probability distribution _G_ ( _ε_ ). We assume that _ε_ is _iid_ and that _G_ ( _ε_ ) is common knowledge, and we will use our novel dataset to parameterize it. The hidden debt issuance shock _ε_ delivers new flows in period _t_ , and it is added to the stock of hidden debt.

**Monitoring.** While the probability distribution for _ε_ is common knowledge, we assume that the level of _h_ is not. Only the country knows its true level of hidden debt, and the lenders (who are risk averse) need to form expectations about this level. Every period, before deciding how many bonds to buy, lenders have an option to “monitor” the country’s statistics: they have to pay a monitoring fee _f_ to trigger a hidden debt revelation (i.e., they learn the true level of hidden debt). If they decide to not exercise this option, they can still buy government bonds but they need to take into account the additional uncertainty of not knowing the true indebtedness of the country. Throughout the paper, we maintain the assumption that this monitoring is the only way (apart from a default) in which lenders

> 24Thus, one may interpret this environment as a game in which the government making decisions in period _t_ is a player who takes as given the (default and borrowing) strategies of other players (governments) who will decide after _t_ .

> 25Arellano and Ramanarayanan (2012) and Hatchondo et al. (2016) allow the government to issue both short-term and long-term debt, and they study optimal maturity and the effects of debt dilution, respectively. Hatchondo et al. (2017) allow the government to issue both defaultable and non-defaultable debt. Roch and Roldán (2023) and Sosa-Padilla and Sturzenegger (2022) allow the government to issue debt with payments contingent on the level of income.

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