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Federal Reserve Bank of Minneapolis
Staff Report
Sovereign risk and firm heterogeneity
Cristina Arellano
Yan Bai
Luigi Bocola
Abstract

This paper studies the recessionary effects of sovereign default risk using firm-level data and a model of sovereign debt with firm heterogeneity. Our environment features a two-way feedback loop. Low output decreases the tax revenues of the government and raises the risk that it will default on its debt. The associated increase in sovereign interest rate spreads, in turn, raises the interest rates paid by firms, which further depresses their production. Importantly, these effects are not homogeneous across firms, as interest rate hikes have more severe consequences for firms that are in need of borrowing. Our approach consists of using these cross-sectional implications of the model, together with micro data, to measure the effects that sovereign risk has on real economic activity. In an application to Italy, we find that the progressive heightening of sovereign risk during the recent crisis was responsible for 50% of the observed decline in output.


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Cristina Arellano & Yan Bai & Luigi Bocola, Sovereign risk and firm heterogeneity, Federal Reserve Bank of Minneapolis, Staff Report 547, 22 Mar 2017.
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Keywords: Sovereign debt crises; Firm heterogeneity; Financial frictions
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