Sovereign debt crises and credit to the private sector☆
Introduction
Emerging markets experienced a lending boom in the late 20th century. This boom was accompanied by a number of sovereign debt restructuring episodes, many of which were followed by economic crises. One channel through which economic activity can be affected by sovereign debt restructuring is the tightening of external financial constraints for private firms. This may be an important channel because the international capital market has become an important source of funds for the emerging markets' private sector. Throughout the lending boom, private sector borrowing accounted for over 30% of total net capital inflows to emerging markets. Currently, about 25% of emerging markets' corporate bonds and bank credit are external, and this number is much larger for Latin American emerging economies.1
To our knowledge, this paper presents the first systematic analysis of the effects of sovereign debt crises on foreign credit to the private sector. Recent empirical work has found various changes in private sector credit patterns in the aftermath of financial crises (Blalock et al., 2005, Desai et al., 2006, Eichengreen et al., 2001, Pasquariello, 2005) as well as changes in stock market behavior (Kallberg et al., 2002, Pasquariello, 2005). The empirical literature regarding the effects of sovereign debt crises has focused on the impact on sovereign borrowing. Eichengreen and Lindert (1989) find that sovereign default does not seem to influence future access of sovereigns to the capital market. This finding is confirmed in a recent study by Gelos et al. (2004) — they find that the probability of the sovereign's market access is not strongly influenced by the sovereign default. On the other side of the debate, Ozler (1993) claims that the countries can only reenter the credit market after settling old debts, and Tomz and Wright (2005) find that over the last 200 years “about half of all defaults led to exclusion from capital markets for a period of more than 12 years.” We focus on the short- and medium-run effects of sovereign debt crises on private firms' access to foreign credit.2
Debt restructuring is a process that may involve a substantial period of time. Because it is possible that the response from both borrowing firms and foreign investors is different during debt renegotiations than it is after the final restructuring agreement, we construct data on the onset of debt renegotiations and consider separately the effects of the renegotiations and the effects of reaching the restructuring agreement. We also analyze the effects of different types of debt restructuring agreements.
Sovereign debt crisis can lead to reduced foreign credit to private domestic firms via a decline in supply, as lenders' perceptions of country risk worsen (Drudi and Giordano, 2000); via a decline in aggregate demand that is triggered by a sovereign debt crisis and its resolution (Dooley and Verma, 2003, Tomz and Wright, 2005); and via exogenous shocks that affect both the probability of sovereign debt crisis and the amount of foreign credit to the private sector. We provide an intuitive discussion of these channels. While our methodology does not allow us to distinguish between the demand and the supply effects, we address the possibility of a common shock.
Our micro-level data on foreign bond issuance and foreign syndicated bank loan contracts come from Bondware and Loanware and cover 30 emerging markets between 1984 and 2004.3 We group privately owned firms into financial and non-financial sectors and split the latter into exporting and non-exporting sectors using information on the export structure of the country. For each sector, we calculate the total amount that firms borrowed in the bond market or from bank syndicates in each month. We also construct a number of indicators that describe various aspects of each country's economy as well as factors that affect the world supply of capital to emerging markets, which we use as control variables. In order to capture country risk premia properly, we exclude from the analysis all foreign-owned firms. We analyze these data using fixed effects panel regressions.
We find systematic evidence of a decline in foreign credit to the private sector in the aftermath of sovereign debt crises. The effects are statistically significant and economically important: After controlling for fundamentals, we find an additional decline in credit of over 20% below the country-specific average during the debt renegotiations, which persists more than two years after the restructuring agreement is reached. In our analysis of different types of debt restructuring agreements, we find that the contraction in foreign credit to the private sector is smaller after agreements with commercial creditors as opposed to agreements with official creditors and that no contraction occurs after voluntary debt swaps and debt buybacks. Furthermore, agreements that include new lending lead to a lower decline in credit than agreements that do not.
The distribution of this decline is uneven across firms: Credit to the exporting sector is not affected during the debt renegotiations but falls after the agreement is reached, while credit to the non-exporting sector falls during the renegotiations and then recovers within a year after the agreement is reached. Credit to the financial firms also contracts after the agreement is reached but by a small amount that is not statistically different from zero. These results are only suggestive since the difference in estimated coefficients across sectors are not statistically significant, potentially due to imperfect sorting of the firms into different sectors.
It is worth emphasizing that in focusing on foreign debt financing of emerging market private firms, we do not analyze capital flows that occur in the form of trade credit, foreign direct investment (FDI), or funds raised on the stock market.4 We also exclude multinational and foreign-owned companies from our sample. Thus, our results are limited to foreign borrowing by private domestically owned firms.
Our findings represent a step towards understanding the costs of sovereign debt crises. Recent models of financial crises in general and debt crises in particular assume that debt crises are costly due to output loss (Arellano, 2004, Arellano and Ramanarayanan, 2006, Yue, 2005). Our paper provides one explanation of the mechanism that could give rise to large output losses as a result of sovereign debt crises, through the amount of credit available to the private sector.5
The remainder of the paper is organized as follows. Section 2 discusses the channels through which sovereign debt crises can affect private firms' foreign borrowing. Section 3 describes the empirical approach and the data. Section 4 presents the results of the empirical analysis and their relation to the mechanism of the transmission of debt crisis effects to private external borrowing. Section 5 concludes.
Section snippets
Sovereign debt crises and lending to the private sector
In this section we provide an intuitive discussion of the channels through which sovereign debt crises can affect foreign credit to domestically owned private firms. We focus on the short-run effects and do not discuss structural changes in the economy, such as entry or exit in certain sectors, or fire-sale FDI activity.
Empirical approach and data sources
We now turn to empirical analysis of this relationship. We look at different measures of credit, as well as various types of debt restructuring agreements.
In order to test for a decline in credit in the aftermath of a sovereign debt restructuring, we estimate the following reduced-form equation, using regressions with fixed effects:where qit is a measure of credit, αi is a set of country fixed effects absorbing the effect of initial conditions, α
Empirical findings
To analyze whether there is a reduction in credit due to sovereign debt crises, we first focus on the medium run, including our main explanatory variable for up to three years. We then repeat the analysis with monthly indicators of the event. Our results are robust with respect to measures, empirical specification, sample, and set of controls, as shown in the working paper version of this study (Arteta and Hale, 2006).
The size of the coefficients in all regressions can be easily interpreted.
Concluding remarks
We empirically find that, during debt renegotiations and in the aftermath of restructuring agreements, foreign credit to emerging market private firms declines by over 20%. We find that the negative impact of debt renegotiations and debt restructuring agreements varies by the type of borrower and is concentrated in the non-financial sector. We find the differences in the response of credit to the exporting and to the non-exporting sectors unexpected and intriguing and believe they deserve
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Overview
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We thank two anonymous referees, Paul Bedford, Doireann Fitzgerald, Oscar Jorda, Enrique Mendoza, Paolo Pasquariello, Kadee Russ, Diego Valderrama, seminar participants at Federal Reserve Bank of San Francisco, Stanford, UC Davis, Cornell, University of Michigan, and the participants at LACEA 2005 and AEA 2006 meetings for their helpful comments. We are grateful to Emily Breza, Chris Candelaria, Rachel Carter, Yvonne Chen, Heidi Fischer, and Damian Rozo for the outstanding research assistance at different stages of this project. We thank Peter Schott for providing export data. All errors are ours. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System.