Sovereign debt and corporate borrowing costs in emerging markets

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    Journal of International Economics 88 (2012) 198208

    Contents lists available at SciVerse ScienceDirect

    Journal of International Economics

    .e lsev ie r .com/ locate / j i edebt, reinforcing the need to better understand the impact of sover-eign debt on corporate borrowing terms.

    How would a higher level of sovereign debtthe foreign borrow-ing of a government entityaffect the costs of corporate borrowingfrom foreign lenders? First, increasing foreign borrowing by govern-ment entities is likely to trigger a reassessment of country risk. Coun-tries with higher public debt face higher risks of a sovereign debtcrisis for a given adverse economic shock and sovereign debt crises

    to foreign debt markets for private sector borrowers from the samecountry. Both corporate and sovereign debts are subject to the samecountry-specic macroeconomic risks. Hence, banks and other credi-tors seeking diversication of their lending portfolio would managetheir overall exposure level to each country, irrespective of whetherthe lending is to a corporation or to the government.1 As a result, in-creased government debt could crowd out corporate borrowingfrom foreign creditors.are known to spread through the economy aworthiness. For instance, sovereign defaults htail the private sector's access to foreign 2008; Kohlscheen and O' Connel, 2008); lo

    Corresponding author.E-mail addresses: (. Aca), ocelasu

    0022-1996/$ see front matter 2012 Elsevier B.V. Alldoi:10.1016/j.jinteco.2012.02.009countries has started toe time, emerging marketheir reliance on foreign

    sovereign debt on the cost of corporate borrowing.In addition, even abstracting from any changes in country risk, in-

    creased government debt could lead to lower and more costly access

    rise after several years of decline. At the samcorporations have considerably increased tSyndicated loansYield spreadsCreditor rights

    1. Introduction

    Corporate access to internationalcapital accumulation and growth in eages between sovereign debt and theternational debt markets are frequentsurprisingly, have not received muchature. This issue has started to attra200809 recession, as public debt inal markets is crucial forng economies. The link-f corporate access to in-ted in policy circles, but,on in the academic liter-wing interest since the

    risk of a banking crisis (Borensztein et al., 2007; Sandleris, 2008).Moreover, even if it does not lead to a sovereign default, higher sov-ereign debt raises the risk of higher future corporate taxation or ex-propriation of private investments as in Aguiar et al. (2009), andAguiar and Amador (2011), while reducing the ability of the govern-ment to honor its implicit guarantees to the private sector. This chan-nel, a sovereign risk effect, would imply an adverse impact of risingCorporate debt

    Sovereign debtSovereign debt and corporate borrowing

    enay Aca a, Oya Celasun b,a George Washington University, United Statesb International Monetary Fund, United States

    a b s t r a c ta r t i c l e i n f o

    Article history:Received 21 December 2010Received in revised form 7 February 2012Accepted 10 February 2012Available online 22 February 2012

    JEL classication:F41G2

    We document that the corpsector is higher. By contrastborrowing costs. An increaswith 9% higher loan yield srights and past sovereignbetween public external de

    j ourna l homepage: wwwnd impair private credit-ave been shown to cur-

    nance (Arteta and Hale,wer international trade (O. Celasun).

    rights reserved.sts in emerging markets

    te sector faces higher borrowing costs when the external debt of the publicsignicant relationship is found between domestic public debt and corporatesovereign debt by one standard deviation from its sample mean is associatedads. The correlation is considerably higher in countries with weak creditorault episodes. Overall, these ndings suggest substantial adverse linkagesnd private nancing costs.

    2012 Elsevier B.V. All rights reserved.The literature also recognizes that sovereign debt can improve pri-vate access to foreign credit. In particular, Dittmar and Yuan (2008)

    1 Bank regulators explicitly advise banks to establish country exposure limits (seefor example, The Ofce of the Comptroller of the Currency, 2008).

  • nd that sovereign bond issuances generate sizable benets for thedevelopment of corporate bond markets in emerging markets. Suchbenets could overturn or weaken the relationship between sover-eign debt and corporate borrowing costs stemming from the sover-eign risk and portfolio crowding out channels.

    This paper examines how the borrowing costs of the corporatesector vary with public debt in emerging market economies using

    other hand, if governments are unable to selectively default on for-eign creditors and instead have to default uniformly on all creditors,a higher level of domestically-held public debt raises the costs of a de-fault on the domestic economy, and, therefore, reduces the govern-ment's incentives to default, as in Basu (2010) and Gennaioli et al.(2011).3 In addition, domestically-held debt does not have a bearingon foreign lenders' portfolios, and therefore would not push up pri-vate borrowing costs through the crowding out channel. The lack ofa signicant correlation between domestic public debt and corporateyield spreads suggests that these mechanisms largely offset eachother.

    199. Aca, O. Celasun / Journal of International Economics 88 (2012) 198208data on syndicated loan issuances from 1990 to 2006.2 Establishingcausation from public debt to the corporate sector's borrowingterms is clearly a challenging task, since a number of imperfectly-observed factorssuch as the cyclical position of the economycould affect both public debt and the creditworthiness of the privatesector. We therefore control for an array of country factors thatcould affect both public debt and private creditworthiness, includingGDP growth, country-xed effects, creditor rights, nancial develop-ment, in addition to the balance sheet, default risk, and protabilityinformation for the borrowers. While these controls should go along way toward mitigating spurious correlations, they do not guar-antee the estimation of causal effects. Hence, our results should beinterpreted as conditional correlations and stylized facts that re-searchers can use and build on.

    Our key nding is that a higher level of sovereign debt is associat-ed with signicantly higher corporate borrowing costs in emergingmarket economies. The correlation is strong and robust to using alter-native specications and controls. Yield spreads on syndicated loansto corporations are higher by 9% if the public external debt-to-GDPratio is higher than its sample mean (21%) by one standard deviation(11%). For a US$147 million loan of four years maturity (roughly theaverage loan size and maturity in the sample) a one standard devia-tion increase in debt would add close to US$1 million to the interestcost over the lifetime of the loan.

    The estimated relationship between sovereign debt and the cost ofcorporate syndicated borrowing is signicantly stronger in economieswhere creditor protection is weak, suggesting that the combination ofhigh sovereign debt and weak creditor rights produces a riskier envi-ronment for creditors. Under weak creditor rights, lenders would beable to recover a smaller share of their investment if the borrower de-faults due to a sovereign-debt driven economic crisis. Thus, when ris-ing sovereign debt heightens the risks of sovereign debt distress,lenders seek extra compensation from private borrowers in countrieswhere they have less legal protection.

    Reinhart and Rogoff (2004) document that sovereign default riskis highly persistent. We examine whether the relationship betweensovereign debt and corporate borrowing costs is different in countriesthat have experienced sovereign default episodes in the recent pastand, therefore, could be perceived to have higher sovereign risk. Wend that an increase in public external debt by one standard devia-tion is associated with a seven times larger increase in yield spreadsin countries that have experienced sovereign defaults in the past ascompared to those that have not.

    In contrast to the robust relationship between public external debtand corporate yield spreads, we do not nd a statistically signicantassociation between domestically-issued public debt and corporateyield spreads. This nding is consistent with the notion that domesticpublic debt can have both positive and negative effects on sovereignrisk. On the one hand, a higher level of domestic public debt contrib-utes to a higher total debt level and reduces the government's abilityto service its debt in the event of a negative output shock. On the

    2 The syndicates providing the loans are predominantly composed of foreign banks.The syndicated loan market is an important source of foreign funding for emergingmarket rms. Corporate borrowing through syndicated loan commitments has in-creased substantially in the last decaderising more than threefold in ve years to

    above $250 billion in 2007.Overall, the evidence presented in this paper is strongly sugges-tive of previously-undocumented, adverse linkages between publicexternal debt and the cost of foreign credit to the corporate sector.The rest of this paper is organized as follows. Section 2 discussesthe specication and estimation method. Section 3 discusses thedata. Section 4 presents the regression results. Section 5 relates thendings to existing literature. Section 6 concludes.

    2. Specication and estimation issues

    We use multivariate OLS regression


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