data, hidden debt revelations are particularly sizeable during sovereign default episodes and IMF programs, when the sovereign’s books come under close scrutiny.<sup>2</sup> Third, we use our new data to shed light on the role of hidden debts during sovereign default episodes and the debt resolution process. One key concern among bondholders during sovereign restructurings is that hidden debt can dilute the recovery value of their own marketable claims. During recent debt restructuring episodes, for example in Zambia, such concerns amplified coordination issues and led to substantial delays in debt resolution, with potentially severe costs for debtors and creditors alike.<sup>3</sup> To systematically analyze the role of hidden debt in default episodes we combine our data on debt under-reporting with data on the outcomes of all sovereign restructurings with private creditors since 1970. We find that higher hidden debt at the onset of a restructuring is associated with both longer restructuring episodes and larger creditor losses, which suggests that high hidden debts do indeed dilute the recovery value of market investors.

Motivated by these findings, we develop a quantitative sovereign debt and default model (in the tradition of Eaton and Gersovitz, 1981, Arellano, 2008, and Aguiar and Gopinath, 2006) with hidden debt, asymmetric information and an endogenous information acquisition problem that generates hidden debt revelations. The sovereign debtor in the model faces an exogenous hidden debt accumulation process that is not observed by investors in the country’s market debt. Each period, however, the investors need to decide whether to monitor the sovereign’s books. In line with our empirical evidence, the model features a recovery rate for market debt that is diluted by undisclosed hidden debts of the sovereign. This aspect gives bond investors further incentives to monitor the sovereign, therefore triggering revelations of hidden debt, particularly during bad times when sovereign default risk is high, just as we observe in the data.

We calibrate this model with our new data and analyze the effects of both hidden debt and its revelation. We show that asymmetric information about the true level of indebtedness has sizeable effects on equilibrium outcomes: The existence of hidden debt increases default incentives and depresses sovereign bond prices. To compensate investors for the uncertainty about true debt levels, sovereign borrowers need to pay higher spreads for given levels of market debt. On the other hand, monitoring-induced revelations of hidden debt are uncertainty reducing and therefore decrease the sovereign’s borrowing costs for a given level of overall debt. If the revealed amount of hidden debt is large, however, the increase in overall debt leads to an increase in spreads that outweighs the spread compression from reduced uncertainty. Thus, our model predicts that the spread response to a revelation increases with the amount of hidden debt that is revealed. We corroborate this finding empirically by running panel regressions of bond price reactions on our new measures of hidden debt revelations.

> 2In contrast, we do not find evidence that governments strategically disclose hidden debts for political gains.

> 3Zambia’s bondholders rejected the government’s first debt relief request citing debt transparency concerns in 2020. The following year the government conceded that its debt had been under-reported. See Financial Times (2020, November 13) _“Zambia on brink of default after lenders reject debt relief request”_ and Financial Times (2020, September 30) _“Bondholders balk at Zambia’s plan to delay debt payments”_ .

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