ESSAYS ON LINKAGES BETWEEN CAPITAL FLOWS, LEVERAGE, AND THE REAL ECONOMY

Abstract

Europe experienced a sovereign debt crisis starting in 2010, in which perceived default risk and interest rates on government bonds soared in many countries, leading to recessions. This episode was preceded by a steady rise in the ratio of corporate debt to GDP, suggesting that private sector leverage may be a contributing factor to rising sovereign risk. In the main essay, I find that corporate debt causally affects sovereign default risk and show that this corporate-sovereign debt nexus is an important amplification mechanism driven by externalities that call for macroprudential policies. I run instrumental variable regressions to estimate a causal relationship running from aggregate corporate leverage to sovereign spreads. I use the weighted sum of idiosyncratic shocks to top 50 large firms in each Eurozone country as an instrument for aggregate corporate leverage to rule out potential reverse causality and omitted variable bias. The regressions suggest that rising corporate leverage causes sovereign spreads to rise, which confirms the existence of the corporate-sovereign nexus. To understand the mechanism, I build a model in which both firms and the government can default. When corporate debt increases, tax revenues are expected to be lower, as firms stop paying taxes and dividends when they default, which raises sovereign default risk. This tax revenue channel is supported by empirical evidence. Country-level tax revenue regressions show that increases in corporate debt-to-GDP ratios reduce future tax revenue growth. Difference-in-difference regressions using firm-level data suggest that highly-leveraged firms reduce tax payments more compared to less-leveraged firms in response to the 2008 global financial crisis. Moreover, I analyze an externality that arises from firms' limited liability, which is distinct from the pecuniary and aggregate demand externalities. I find that there exist time-consistent optimal policies that correct the limited liability externality. A quantitative model calibrated to six Eurozone countries shows that such policies consists of a low constant debt tax rate together with transfers and investment credits to firms during the crisis. Implementing these policies alleviates the corporate-sovereign linkage, so that the number of defaulting firms decreases, and the government has enough fiscal space to provide transfers to households suffering from low consumption. Furthermore, practical policies such as either constant or cyclical debt tax schedules can correct overborrowing externalities. However, a countercyclical debt policy (which raises the debt tax rate during corporate credit booms) induces more firm defaults during crises, and thus it is less effective than constant and procyclical debt tax policies. This suggests that policymakers should be cautious about implementing countercyclical debt tax policies such as countercyclical capital buffers, and should even consider relaxing regulations when corporate default risk is high. The second essay (co-authored) documents new facts on the relationship between sector-level capital flows and sectoral leverage. We highlight the interconnections between different approaches and argue that harmonization of the macro and micro approaches can yield a more complete understanding of these effects of capital flows on country-, sector- and firm/bank-level leverage associated with credit booms and busts. The third essay (co-authored) uses a historical quasi-experiment in the Ottoman Empire to estimate the causal effect of trade shocks on capital flows. We argue that fluctuations in regional rainfall within the Ottoman Empire capture the exogenous variation in exports from the Empire to Germany, France, and the U.K., during 1859-1913. Our identification is based on the following historical facts: First, only surplus production was allowed to be exported in the Ottoman Empire (provisionistic policy). Second, different products grew in different regions that were subject to variation in rainfall. Third, Germany, France, and the U.K. imported these different products. When a given region of the Empire gets more rainfall than others, the resulting surplus production is exported to countries with higher ex-ante export shares for those products, and this leads to higher foreign investment by those countries in the Ottoman Empire. Our findings support theories predicting complementarity between trade and finance, where causality runs from trade to capital flows.