Economic Research - 18 December 2018 - How is a firm’s credit risk affected by sovereign risk? - By Johannes Breckenfelder[1]
When a country sees its sovereign credit risk rise, do companies in that country also see their credit risk increase? We show that the answer is yes. Companies with a large public-sector ownership, as well as companies that borrow heavily from banks, are most affected. This suggests that the transmission of credit risk from sovereigns to non-financial companies occurs primarily through a fiscal and a financial channel, and points to the importance of reducing such risk spillovers and thereby overall risk in the economy, e.g. by means of the capital markets union.
When investors perceive a country to be more likely to default on its debt, the interest rates paid on the debt securities of that sovereign increase in order to compensate investors for the higher perceived default (or credit) risk. In such situations, it is often the case that banks and other financial intermediaries in that country see their credit risk and funding costs increasing as well. History has shown that if such a “spillover” of sovereign distress to the financial sector is strong enough, it can be associated with real economic costs (see, for example, Reinhart and Rogoff (2008)).
We saw an example of that during the 2010 European sovereign debt crisis, with sovereigns in several euro area countries facing a rise in credit risk. While many empirical studies have demonstrated the existence of this so-called sovereign-bank loop, this Research Bulletin article addresses the question whether sovereign risk can also affect companies outside the financial sector. More precisely, it asks: Does sovereign risk affect or “spill over” to the credit risk of non-financial corporations? If so, through which channels does the spillover occur? The answers to these questions build on the results of a recent study by Augustin, Boustanifar, Breckenfelder, and Schnitzler (2018).
How does sovereign risk spill over to corporate credit risk?
Conceptually, sovereign and corporate credit risks can be linked either directly or indirectly. Indirectly, increased sovereign risk may simply signal bad macroeconomic fundamentals, which may in turn adversely impact corporates’ profitability, making corporations’ debt riskier. Directly, increased sovereign risk may have an impact on corporate credit risk via two channels. First, there is a fiscal channel, whereby increased sovereign risk may force a government to take fiscal actions that affect corporations by, for example, increasing taxation, reducing subsidies, or lowering the value of implicit and explicit government guarantees. Second, there is a financial channel, whereby increased sovereign risk worsens the health of the domestic financial sector (the sovereign-bank loop) which in turn is passed on to non-financial corporations via less favourable bank lending conditions.
Empirical evidence on the sovereign to corporate risk spillovers
Documenting the credit risk transmission between sovereigns and firms is empirically challenging as there are potential linkages between a government and the corporate sector that may give rise to biased or spurious interpretations. In the above-mentioned study, we address such challenges by exploiting the announcement of the first Greek bailout on 11 April 2010, a critical event in the European sovereign debt crisis. Importantly, instead of having a calming effect on the market, the bailout triggered a dramatic increase in the yields on Greek government bonds and in alternative measures of risk of the Greek sovereign such as credit default swap (CDS) spreads, which reflect the expected probability of a sovereign default, and its bid-ask spreads, which reflect liquidity risk. This is illustrated in Figure 1, with Greek CDS spreads increasing from an average of 337 basis points in the few months prior to the bailout (bps) to an average of 697 bps in the months following the bailout, and bid-ask spreads increasing from about 10 bps to about 35 bps over the same periods.
Copyright: European Central Bank
Directorate General Communications
Sonnemannstrasse 20, 60314 Frankfurt am Main, Germany
Tel.: +49 69 1344 7455, E-mail: media@ecb.europa.eu
Website: www.ecb.europa.eu
page source https://www.ecb.europa.eu/
