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Sovereign Default Risk and Firm Heterogeneity

Staff Report 547 | Revised December 8, 2020

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Cristina Arellano Assistant Director, Policy and Monetary Advisor
Yan Bai University of Rochester and NBER
Luigi Bocola Stanford University and NBER
Sovereign Default Risk and Firm Heterogeneity


This paper measures the output costs of sovereign risk by combining a sovereign debt model with firm- and bank-level data. In our framework, an increase in sovereign risk lowers the price of government debt and has an adverse impact on banks' balance sheets, disrupting banks' ability to finance firms. Importantly, firms are not equally affected by these developments: those that have greater financing needs and borrow from banks that are more exposed to government debt cut their production the most in a debt crisis. We use Italian data to measure these firm-level elasticities and use them as empirical targets for estimating the structural model. In a counterfactual analysis, we find that heightened sovereign risk was responsible for one-third of the observed output decline during the Italian debt crisis.