Corporate Balance Sheets and Sovereign Risk Premia

60 Pages Posted: 20 Oct 2020

See all articles by Steve Pak Yeung Wu

Steve Pak Yeung Wu

University of California, San Diego (UCSD) - Department of Economics

Date Written: March 2020

Abstract

This paper studies sovereign debt pricing in the presence of corporate debt. We find that foreign currency (FC) corporate external debt empirically explains sovereign credit spreads in emerging countries, even after controlling for sovereign debt and global factors. Decomposing sovereign credit spreads into their default premium (default probability) and risk premium components, we find that a 1% increase in FC corporate external debt is associated with a 5 basis point increase in the sovereign risk premium but a small and insignificant change in the sovereign default premium. We incorporate a productive corporate sector and risk-averse foreign lenders into a quantitative sovereign default model. An increase in FC corporate external debt has three effects on tax revenue, and thus sovereign spreads. It increases the mean of tax revenue due to higher investment, increases the variance of tax revenue due to higher exposure to exchange rate risk, and changes the covariance of sovereign defaults and the state of foreign lenders due to the safe currency property of FC. The first two effects counteract each other and help explain the insignificant change in the sovereign default premium, while the third effect results in a higher sovereign risk premium. Corporates do not internalize their effect on sovereign debt pricing, leaving room for policy improvement.

Keywords: sovereign risk, corporate debt, currency mismatch

JEL Classification: F34, F41, G12, G15, G38

Suggested Citation

Wu, Steve Pak Yeung, Corporate Balance Sheets and Sovereign Risk Premia (March 2020). Available at SSRN: https://ssrn.com/abstract=3685278 or http://dx.doi.org/10.2139/ssrn.3685278

Steve Pak Yeung Wu (Contact Author)

University of California, San Diego (UCSD) - Department of Economics ( email )

9500 Gilman Drive
La Jolla, CA 92093-0508
United States

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