Sovereign Risk and Economic Activity: The Role of Firm Entry and Exit

Abstract

We quantify the role of firm entry and exit in shaping the output costs of sovereign debt crises. Empirically, higher sovereign risk correlates with less firm entry and more exits. We find evidence of a credit-supply channel explaining the sovereign risk-entry relationship but not for the sovereign risk-exit relationship. We develop a model with sovereign risk, financial frictions and endogenous firm dynamics. Calibrated with data around the Portuguese debt crisis, the model predicts that sovereign risk explains 60% of the fall in entry and most of the exit dynamics. The extensive margin explains 80% of the output fall in the long-run.

Keywords: Sovereign Debt Crises, Financial Frictions, Firm Dynamics

JEL Classification: E32, E44, F34, G15