Sovereign Default Risk and Firm Heterogeneity

Abstract

This paper measures the output costs of sovereign risk by combining a sovereign debt model with firm-and bank-level data. In our framework, an increase in sovereign risk lowers the price of government debt and has an adverse impact on banks' balance sheets, disrupting their ability to finance firms. Importantly, firms are not equally affected by these developments: those that have greater financing needs and borrow from banks that are more exposed to government debt cut their production the most in a debt crisis. We show that the response of aggregate output to an increase in sovereign risk depends on these cross-sectional firm-level elasticities. We use Italian data to measure them and parameterize the model to match the cross-sectional facts. In counterfactual analysis, we find that heightened sovereign risk was responsible for one-third of the observed output decline during the 2011-2012 crisis in Italy.

Winners and Losers from Sovereign Debt Inflows

“…6 Our findings are in line with the evidence in these studies even though we exploit events which reduce government financing costs, rather than increase them. They are consistent also with the theoretical predictions in Gennaioli et al (2014) -according to which changes in sovereign default risk and sovereign bond yields can transmit to firms through the balance sheet of banks holding government bonds 7 -and Arellano et al (2017) -according to which firms with larger external financing needs are more sensitive to changes in sovereign default risk. Additionally, our findings are related to numerous studies analyzing how exchange rate movements affect the terms of trade of a country and, therefore, domestic firms.…”

Default Risk, Sectoral Reallocation, and Persistent Recessions

“…This paper contributes to this literature by making sovereign credit market conditions directly affect private borrowing rates for investment. Arellano et al (2017) document the spillover from the sovereign to the private financial conditions using firm-level data. Consistent with this paper, they find that these spillovers were important during the European debt crisis.…”

Sovereign Debt Restructurings

“…An economic interpretation of these shocks is that they capture, in reduced form, costs and benefits of default, restructuring, and portfolio characteristics that are not related to our state variables (current debt portfolio and income). The shocks affecting more directly the default decision are now more common in the literature (see for example AAHW and Arellano, Bai, & Bocola, 2017). They may capture additional costs or benefits of default, such as the perceptions of policy makers of the costs of default.…”