Sovereign Default Risk and Firm Heterogeneity
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.
Document Object Identifier (DOI): 10.3386/w23314
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