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 measure the extent of this heterogeneity using Italian data and parameterize the model to match these 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.

Quantitative sovereign default models and the European debt crisis

“…This contrasts with the findings of two large and growing literatures. One literature documents the pass-through of government interest spreads on private interest rates (Bocola (2016) and Arellano et al (2017)). Another literature emphasizes that the composition of holdings of government debt is an important determinant of interest rate spreads and debt sustainability more broadly (Perez 2015 Dovis et al (2016), and D'Erasmo and Mendoza (2013)).…”

History Remembered: Optimal Sovereign Default on Domestic and External Debt

“…They show how lack of commitment and fiscal policy coordination leads countries to overborrow due to a fiscal externality, focusing on public debt traded across countries by risk-neutral investors, instead of default on risk-averse domestic debt holders. Andreasen et al [7] and Jeon and Kabukcuoglu [38] study models in which domestic income heterogeneity plays a role in the determination of external defaults, and Arellano et al [9] and Rojas [49] study sovereign risk in models with heterogeneous firms.…”

“…The aggregate state variables are B and g. 9 The optimal debt issuance and default decision rules are characterized by the recursive functions B ′ (B, g) and d(B, g) ∈ {0, 1}, respectively. 10 The probability of default at t + 1 evaluated as of t, denoted p(B ′ , g), is:…”

History Remembered: Optimal Sovereign Default on Domestic and External Debt

“…Andreasen et al [7] and Jeon and Kabukcuoglu [33] study models in which domestic income heterogeneity plays a role in the determination of external defaults, and Arellano et.al. [9] and Rojas [49] study sovereign risk in models with heterogeneous firms.…”

“…To characterize these equilibria, we first rewrite the optimization problem of domestic agents and the no-arbitrage condition of foreign investors in recursive form. The aggregate state variables are B and g. 9 The optimal debt issuance and default decision rules are characterized by the recursive functions B (B, g) and d(B, g) ∈ {0, 1}, respectively. 10 The probability of default at t + 1 evaluated as of t, denoted p(B , g), is:…”