A Causal Linkage: Corporate Debt and Sovereign Spreads

This study shows that corporate debt accumulation during credit booms can explain increases in sovereign risk during stress periods. Using detailed firm-level database across six Eurozone countries, I construct granular instruments for aggregate corporate leverage. Instrumental variable regressions indicate that rising corporate leverage causally increases sovereign spreads in Eurozone countries during the debt crisis period of 2010-2012. This result provides the first empirical evidence on the causal link between corporate debt and sovereign debt crises. Additionally, firm-level evidence suggests that highly leveraged firms are likely to pay fewer taxes to the government, contributing to the rise in sovereign risk. (JEL F34, F41, G32, L11)