In sickness and in debt: The COVID-19 impact on sovereign credit risk

The COVID-19 pandemic provides a unique setting in which to evaluate the importance of a country’s fiscal capacity in explaining the relation between economic growth shocks and sovereign default risk. For a sample of 30 developed countries, we find a positive and significant sensitivity of sovereign default risk to the intensity of the virus’s spread for fiscally constrained governments. Supporting the fiscal channel, we confirm the results for Eurozone countries and U.S. states, for which monetary policy can be held constant. Our analysis suggests that financial markets penalize sovereigns with low fiscal space, impairing their resilience to external shocks.