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

Author

Listed:
  • Alberto Montagnoli
  • Miroslava Quiroga-Trevino
  • Christoph Thoenissen

Abstract

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 experienced higher credit crunches and investment declines. To explore the underlying mechanisms, we estimate 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. A counterfactual scenario without bank-held sovereign bonds isolates the contribution of the balance sheet channel: removing this channel weakens the crowding-out effect, with investment falling 0.2 percentage points less and output increasing by 0.02 percentage points more. These effects appear stronger during the financial and sovereign debt crises.

Suggested Citation

  • Alberto Montagnoli & Miroslava Quiroga-Trevino & Christoph Thoenissen, 2025. "The Balance Sheet Channel of Fiscal Policy: Sovereign Exposure and Credit to Firms in the European Periphery," Working Papers 2025-12, Banco de México.
    • Handle: RePEc:bdm:wpaper:2025-12
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    File URL: https://www.banxico.org.mx/publications-and-press/banco-de-mexico-working-papers/%7B3AC95C66-A9B4-FB32-B590-07637FC2E803%7D.pdf
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    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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