Sovereign Default Risk and Credit Supply: Evidence from the Euro Area

TL;DR

This paper examines how sovereign default risk during the European debt crisis impacted macroeconomic activity by reducing credit supply and private lending in affected euro-area countries.

Contribution

It introduces a structural panel VAR model with sign restrictions to identify sovereign risk shocks and analyze their effects on credit and economic activity.

Findings

Sovereign risk decline led to reduced private lending.

Bank asset values decreased due to sovereign risk.

Economic activity contracted in affected countries.

Abstract

Did sovereign default risk affect macroeconomic activity through firms' access to credit during the European sovereign debt crisis? We investigate this question by a estimating a structural panel vector autoregressive model for Italy, Spain, Portugal, and Ireland, where the sovereign risk shock is identified using sign restrictions. The results suggest that decline in the creditworthiness of the sovereign contributed to a fall in private lending and economic activity in several euro-area countries by reducing the value of banks' assets and crowding out private lending.