Property Rights Gaps and CDS

An increase of 100 basis points in the sovereign's CDS spread translates into a rise of 71 basis points in corporate CDS spreads.

When a nation is on the brink of sovereign default, there's always the risk that it will raid its private sector for tax revenue -- or even take it over in search of funds. That's one reason that the credit risks of a nation's corporate sector tend to rise when the nation's sovereign default risks go up. But the strength of that relationship varies across corporations and nations, according to Jennie Bai and Shang-Jin Wei. In When Is There a Strong Transfer Risk from the Sovereigns to the Corporates? Property Rights Gaps and CDS (NBER Working Paper No. 18600), they find that when sovereign default risks rise, credit risks increase more for state-owned companies than non-state-owned companies, and more in nations with weak property rights institutions than in nations with strong ones. "Those institutions that place an effective check and balance on the government tend to weaken the connection between sovereign and corporate credit risks," the authors write. "On the other hand, institutions that are mainly designed to strengthen protection of creditor rights or minority shareholder rights do not appear to matter much in this context."

As the sovereign debt crisis has unfolded, the market for sovereign credit default swaps (CDS) has grown rapidly. For example, in a single year -- from March 2009 to March 2010 -- the volume of outstanding Italian sovereign CDS grew 37.5 percent to $223.3 billion. For Spain, it rose 53.1 percent; for Greece, it doubled.

The authors study CDS spreads -- rather than traditional bond-market data for nations and companies -- for several reasons. Because a nation's CDS is denominated in foreign currency, inflation does not affect these spreads as it does sovereign debt. As over-the-counter market instruments, CDS prices are not easily manipulated by governments the way that government bond yields can be. And though they have a much shorter history than traditional bonds, corporate CDS offer a straight-forward comparison with sovereign risk without requiring adjustments for extraneous changes in corporate bond risk that aren't connected to changes in sovereign risk.

Examining governments and 2,745 corporations in 30 countries over two years, the authors find that an increase of 100 basis points in the sovereign's CDS spread translates into a rise of 71 basis points in corporate CDS spreads, all things being equal. The authors explain as follows: "If a government is short of money, it could either persuade the central bank to inflate away the government debt, or more likely, pass the debt problem onto the corporate sector by raising tax revenue." But the authors find that the strength of that relationship varies. For example, the strongest correlation is reflected by state-owned companies. Their elasticity is an average 47 basis points higher than that of non-state-owned companies.

The correlation also depends on the country. Of the 30 nations in the study, the five with the highest sovereign-corporate risk correlation are Malaysia, Philippines, South Korea, Mexico, and Russia. The five countries with the lowest correlation are the United States, Norway, Japan, Belgium, and Germany. The latter group all fall within the ranks of nations with the largest constraints on government expropriation of private property, including constraints on the executive and the importance of the rule of law. All five nations in the former group rank lower down.

It is possible that causation could flow the other way. A rise in corporate risk could lead to a rise in sovereign risk if, for example, a deterioration of corporate fundamentals in the private sector forced a government takeover. But by using "price discovery" tools, the authors find that is unlikely to be the case. In most cases sovereign CDS spreads are an important driver for corporate CDS spreads in nations with weak property-rights institutions (and less so in nations with strong property-rights institutions).

"Sovereign risk on average has a statistically and economically significant influence on corporate credit risk," the authors conclude. But "not all governments have an equal ability to expropriate the private sector. In particular, the 'transfer risks' are more subdued and constrained in countries with stronger property rights institutions."

--Laurent Belsie