State‐owned firms and private debt

We study the role of private debt financing in reducing government transfers and information costs in a state‐owned firm. We show that debt contracts allow the government to reduce socially costly subsidies by letting underperforming state‐owned firms default. When the firm has private information, the government uses debt to reduce the firm's information rents. The option of default and privatization allows the government to stop subsidizing the firm. We identify the conditions under which information costs outweigh privatization costs and a positive debt level benefits governments.