Sovereign To Corporate Credit Risk Spillovers
McGill University, Desautels Faculty of Management
BI Norwegian Business School
European Central Bank (ECB) – Financial Research
VU University Amsterdam – Faculty of Economics and Business Administration
January 18, 2016
Using the announcement of the first Greek bailout on April 11, 2010, we quantify significant spillover effects from sovereign to corporate credit risk in Europe. A ten percent increase in sovereign credit risk raises corporate credit risk on average by 1.1 percent after the bailout. These effects are more pronounced in countries that belong to the Eurozone and that are more financially distressed. Bank dependence, public ownership and the sovereign ceiling are channels that enhance the sovereign to corporate risk transfer.
Sovereign To Corporate Credit Risk Spillovers – Introduction
Financial crises tend to be followed by sovereign distress, which is typically associated with real economic costs. Uncertainty about a government’s commitment to service debt payments may restrict its access to capital markets and cause a loss in reputation. Such risk may spill over into corporations through expected increases in taxation, reductions in subsidies or the decreased value of implicit and explicit government guarantees. Acharya, Drechsler and Schnabl (2014) use the recent bailout of Irish banks as a motivation to quantify the risk transfer from financial institutions to the public balance sheet and the subsequent feedback effect onto the financial sector. The sovereign-bank nexus has received considerable attention in light of the sovereign distress wave that followed the 2007-2009 financial crisis.1 In contrast, there is little empirical evidence that sovereign credit risk transmits into the non-financial corporate sector. While it is tempting to believe that the empirical evidence on the relationship between sovereigns and financial institutions carries forward to non-financial institutions, anecdotal evidence highlights that this relationship is not obvious. For example, a FitchRatings’ special report on the Eurozone crisis claimed:
”So far, the only corporates outside Greece to have experienced sovereign-driven rating action have been utilities.” They further state that ”the market broadly agrees with a level of credit separation between Eurozone sovereigns and corporates.”
In this paper, we quantify the spillover effects from sovereign into corporate risk. Identifying the direction of the spillover effect is challenging as there exist intricate linkages between a government and the corporate sector that give rise to causal, reversed, or spurious interpretations. We address these challenges by building on a quasi-experimental design. More specifically, this paper exploits the announcement of the first Greek bailout on April 11, 2010, which led to a significant increase of sovereign risk of all European countries. This allows us to rely on exogenous variation in sovereign credit spreads to quantify a direct spillover effect from sovereign to corporate credit risk. We use credit default swaps (CDS) to capture daily changes in credit risk and rely on a sample of 226 firms from fifteen European countries.3 Our main findings suggest an increase of the interdependence between sovereign and corporate CDS that is due to the unanticipated shock to sovereign credit risk. We estimate that, post-bailout, a ten percent increase in the level of sovereign credit risk is associated with a 1.1 percent increase in the level of corporate credit risk. This relation was insignificant prior to the event.
The Greek bailout was a central event in the European sovereign debt crisis on several important dimensions. First, instead of having a calming effect on the market, it triggered a large increase in Greek CDS spreads. This is illustrated in Figure 1, with Greek CDS spreads increasing from an average of 337 basis points (bps) to an average of 697 bps after the bailout. Second, the bailout is the first explicit violation of the no-bailout clause of the Maastricht Treaty, making its implementation uncertain. Third, after requesting financial support, official statistics on the economic outlook had to be revised. This includes, among others, the upward revision of Greece’s 2009 budget deficit and the downgrade of Greek bonds to junk status by Standard&Poor’s (S&P). Overall, the Greek bailout required immediate transfer payments from other European Union (EU) member states and raised the likelihood that more transfers will follow. Following the bailout announcement, the level of credit spreads unilaterally increased across Europe. We argue that the bail-out suddenly raised the credit risk of other European governments, which in turn affected the credit risk of non-Greek European corporations.
Our identifying assumption is that the Greek bailout affects European corporations solely through sovereign risk. As Greece is a fairly small economy whose industry is dominated by tourism and shipping, a sovereign shock that originates in Greece and that has a negative impact on its local economy is unlikely to directly affect the credit risk of Europe’s largest corporations. We provide two falsification tests that aim at capturing the direct exposure to Greece. First, we compute the consolidated foreign bank claims vis-a-vis Greece for each country relative to its GDP. Countries relatively more exposed to Greece do not reflect greater spillover effects. Second, we test whether companies with subsidiaries in Greece are more strongly affected by an increase in sovereign credit risk, a conjecture that the data does not support. Lastly, we emphasize and show that our sample period coincides with a recovery of corporate fundamentals following the financial crisis. This mitigates concerns that the documented effects arise endogenously because of a downward trend in the aggregate economy rather than a shock to sovereign credit risk.
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