The Asymmetric Pass-Through of Sovereign Risk
-Money Macro Seminar
Abstract: This paper studies the macroeconomic effects of increases in corporate risk around sovereign debt crises. I use a heteroskedasticity-based approach to estimate the causal effect of sovereign risk on the credit risk of non-financial firms. Using Italian firm-level data for the last European debt crisis, I find that sovereign risk accounts for almost a third of the total increase in corporate risk and that this effect is stronger for riskier firms. I use bank-level data to show that the bank-lending channel plays an important role in this transmission. I find that banks with higher sovereign debt holdings exhibit a larger increase in their corporate non-performing loans. Increases in sovereign risk thus weaken banks' balance sheets directly, by decreasing the value of government bonds held by banks, and indirectly, through banks' exposures to non-financial firms. I formulate a heterogeneous-firms model where the banking sector transmits sovereign risk to firms and show it is able to match the empirical relationships estimated from Italian data. In a counterfactual analysis, I find that corporate risk represents a quantitatively important feedback mechanism that further deteriorates banks' balance sheets, amplifying the size and persistence of a sovereign debt crisis. I study different policies that can mitigate the negative effects of sovereign risk and identify efficiency gains from policies that exploit firms' heterogeneous reactions to increases in sovereign risk.