Creator: Arellano, Cristina, Bai, Yan, Bocola, Luigi, and test Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 547 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.
Keyword: Micro data, Sovereign debt crises, Firm heterogeneity, Financial intermediation, and Business cycles Subject (JEL): F34 - International Lending and Debt Problems, G15 - International Financial Markets, E44 - Financial Markets and the Macroeconomy, and G12 - Asset Pricing; Trading Volume; Bond Interest Rates