Real Effects of the Sovereign Debt Crisis in Europe: Evidence from Syndicated Loans

In this paper, we explore the impact of the European Sovereign Debt Crisis and the resulting credit crunch on the corporate policies of firms. Existing theory suggests that sovereign crises can affect the real economy in complex ways based on the nature of the interaction between bank and sovereign health. We show that banks' exposures to impaired sovereign debt and risk-shifting behavior of undercapitalized banks are of first-order importance for explaining the negative real effects suffered by European firms, while moral suasion by governments to buy more domestic sovereign debt does not seem to have played a major role. In particular, we present firm-level evidence showing that the lending contraction at banks affected by the crisis depresses the investment, job creation, and sales growth of firms with significant business relationships to these banks. These firms increase their precautionary motives to save cash out of free cash flows and rely more on cash holdings than bank lines of credit for their liquidity management during the crisis, a typical behavior of financially constrained firms. Our estimates suggest that the credit crunch explains between one fifth and one half of the overall negative real effects in the sample.