State Owned Firms: Private Debt, Cost Revelation and Welfare

In this paper we study the role of private debt financing in disciplining a state owned firm operating for a government that incurs a cost of public financing. We show that debt contracts allow the government to avoid socially costly subsidies by letting unprofitable state- owned firms default. Debt is never used when the firm and government share the same information about the firm. By contrast, when the state-owned firm has private information, the government has an incentive to use debt to reduce the firm's information rents. We identify the conditions under which a positive debt level benefits governments. They depend on the cost of public funds, the interbank funding rate, the share of foreign investors, the level and uncertainty of the firm's cost.