Balance hidrológico superficial de la cuenca del Río Tecoripa

The credit risk and spread on sovereign debt is an important economic consideration and it has real economic consequences, particularly for firms within the country in question and their ability to access international capital markets.

In general, there are at least two ways that sovereign debt distresses can spillover into the wider economy, and thus into corporate spreads which would impact the cost of borrowing for ESBN. On the demand side, default periods often lead to reduced levels of output and domestic demand (Borrenzstein and Panizza, 2008) and an associated reduction in investment, profit. These impacts may be intensified by banking sector instability. Overall, firms may become more risk adverse, demand less credit and reduce their cost base. On the supply side, increases in sovereign debt spreads may worsen the overall perceived level of country risk leading to, inter alia, reductions in private sector debt issuance.

Another way of examining the impact of sovereign spreads on corporate debt, provided by one Paper at the South Western Finance Conference11, is that rating agencies generally do not assign ratings to debt issuers that are higher than their home country’s sovereign rating, therefore, sovereign ratings influence the ratings given to provincial governments, and the firms headquartered in the same country. Alternatively, the sovereign rating could reduce the availability of the company to access the credit markets via a rated bond issue. This directly impacts the ability of firms in that country to access international capital markets (Martell, 2005).

11_{Examining the relationship between sovereign credit ratings and economic freedom, conference paper, south western}

Some research has investigated the link between sovereign default and costs for the domestic economy (Cole and Kehoe, 1998; Alfaro and Kanczuk, 2005; Sandleris, 2006; and Mendoza and Yue, 2008). In a recent IMF working paper, The cost of aggressive sovereign debt policies: how much is the private sector affected, Trebesch (2009) finds that aggressive debt policies (i.e., fiscal spending via debt) cause a reduction in credit for the private sector of 57% per month relative to what it would have been otherwise. This impact also appears to be lasting and the study also finds that debt policies which are in default have a strong impact for up to two years after the crisis. Moreover, Arteta and Hale (2008) find that sovereign debt crises have a strong negative impact on private sector access to international debt markets; controlling for fundamentals and external shocks, the study shows that foreign loans and bond issuance by domestic firms falls by more than 20%. The study also finds that the decline in foreign credit to domestic private firms is concentrated in the non-financial sector. Furthermore, sovereign debt difficulties can result in risk spillovers whereby aggressive debt policies have adverse consequences across a range of economic agents within the country. One explanation is the role of reputation; and this has been pointed out previously in the literature (Sandleris, 2006; Cole and Kehoe, 1998).

According to the Paper from the South Western Finance Conference, one further implication of sovereign credit ratings in terms of the spillover affect into the real economy is that they partly determine the level of foreign direct investment (FDI). This is particularly important for Ireland given the ‘crucial importance’ of Ireland’s competitive position in the global FDI markets (Barry and Bergin, 2010). As an FDI-intensive country, Irish economic recovery will be determined, in part, by its ability to continue to attract FDI. Therefore, the recent downward revisions in Irish sovereign debt may have longer lasting impacts on the cost of corporate borrowing in the Irish case.

In order to take account of the financial crisis and the uncertainty this involves, two things should have been done. Taking account of uncertainty could have proceeded via the risk- free rate or via the risk-premia; of the debt spread and the ERP. A practical approach would have been to take account of the crisis by using the Irish government bond yield as an estimate of the risk free rate, although we accept that such bonds are not perceived as risk free. We take no issue with the approach adopted by Europe Economics that the Irish government rate might not be risk-free, but then any additional risk premia should be reflected in the risk premiums for debt and equity of Irish companies.

Explicit account should have been taken of the financial crisis, and the medium term impacts of this on the overall cost of debt in Ireland, and then a methodology consistent with the German bond rate as the risk free rate should have been used to estimate the debt spread.

Second, data on ERP should be made as up-to-date as possible, and any sovereign risk premium should show up in the equity risk premium. If the equity markets are inherently more volatile, then some adjustment to the cost of equity should be made. Based on the data from table 4.1, there is clearly a relationship between volatility and equity risk premium.

Figure 3.4: Relationship between historical equity market returns and volatility

ERP by Country versus Standard Deviation

y = 2.2677x + 1.3912 R2 _{= 0.646} 0 2 4 6 8 10 12 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

Standard Deviation Returns

E R P % R e tu r ns Arith mean Linear (Arith mean)

Note:

Source: Indecon/LE analysis of data from Dimson, Marsh and Staunton, which was presented by Europe Economics

As a result of not taking sufficient account of the ongoing higher costs of debt in Ireland, Europe Economics underestimates the cost of WACC.