Corporate-Sovereign Debt Nexus and Externalities

85 Pages Posted: 29 Jan 2021

Date Written: December 8, 2020

Abstract

I show that corporate debt accumulation during booms can explain increases in sovereign risk during stress periods. Using idiosyncratic shocks to large firms as instruments for aggregate corporate leverage, I show that rising corporate leverage during the period 2002-2007 causally increases sovereign spreads in six Eurozone countries during the debt crisis period of 2008-2012. To explain these findings, I build a dynamic quantitative model in which both firms and the government can default. Rising corporate debt increases sovereign default risk, as tax revenues are expected to decrease. Externalities arise because it can be privately optimal but socially suboptimal for firms to default given their limited liability. The fact that firms do not take into account the effect of their debt accumulation on aggregate sovereign spreads is an important externality, rationalizing macroprudential interventions in corporate debt markets. I propose a set of such optimal debt policies that reduce the number of defaulting firms, increase fiscal space, and boost household consumption during financial crises. Both constant and countercyclical debt tax schedules can correct overborrowing externalities. Contrary to conventional wisdom, countercyclical debt policy is less effective than constant debt policy, as the countercyclical policy induces more firm defaults.

Keywords: Sovereign Risk, Corporate Debt, Limited Liability, Externalities, Macro- prudential Policy, Granular Instrumental Variables

JEL Classification: F34, F38, F41, G33, L11

Suggested Citation

Kwak, Jun Hee, Corporate-Sovereign Debt Nexus and Externalities (December 8, 2020). Available at SSRN: https://ssrn.com/abstract=3741764 or http://dx.doi.org/10.2139/ssrn.3741764

Jun Hee Kwak (Contact Author)

University of Maryland ( email )

College Park
College Park, MD 20742
United States

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