The Balance Sheet Channel of Fiscal Policy: Sovereign Exposure and Credit to Firms in the European Periphery

This paper provides empirical evidence on the balance sheet channel of fiscal policy in peripheral European economies. Our findings using a Panel VAR, reveal that shifts in financial institutions’ balance sheets following a debt-financed fiscal expansion reduce credit provision and investment in these countries. Moreover, the analysis indicates that economies with higher sovereign exposure experience more severe credit crunches and investment declines. To explore the underlying mechanisms, we employ a DSGE model that incorporates banks as primary holders of sovereign debt. The model shows that sovereign exposure amplifies the negative effects on credit supply, lowering investment and capital formation.