Transfer of Sovereign Credit Risk to Corporate Borrowing Costs, Evidence from the European Debt Crisis

Abstract: This paper studies whether a risk transfer relationship exists between sovereigns and domestic firms in developed economies. We provide empirical evidence that increases in a government's perceived credit risk have considerable negative implications on its private sector by increasing firm cost of borrowing. We study the events of the European sovereign debt crisis by analysing CDS data of 15 European sovereigns and 230 firms spanning from 2010-12. Our analysis is furthered by exploiting the announcement of the first Greek bailout on April 23, 2010 in an event study approach with panel data to evaluate the impact of a negative exogenous shock to credit risk. Underlying the analysis is an in-depth study of cross sectional differences in the sovereign to firm transfer relationship between Financial and non-Financial companies, countries inside and outside the Eurozone, and between the PIIGS economies and other European countries. The impact of transmission channels in the form of property rights institutions, and a firm's dependence on external borrowing are evaluated. Our results indicate that a 1% increase in sovereign credit risk results in a 0.12% to 0.14% increase in corporate borrowings costs. Evidence suggests pronounced differences in the transfer relationship between Eurozone and non-Eurozone economies, with the effect strongest for non-financial companies in the PIIGS countries. The transfer is weakened in countries with strong property rights and strengthened amongst Eurozone firms highly dependent on borrowing. Notably, we find no difference in the transfer relationship between financial and non-financial companies. Our paper brings to light some of the real effects of the sovereign debt crisis and the importance of fiscal discipline in a common currency union.