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

Alberto Montagnoli, Miroslava Quiroga-Trevino and Christoph Thoenissen

No 2025-12, Working Papers from Banco de México

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.

Keywords: SVAR; DSGE; Bayesian estimation; Fiscal policy; Sovereign debt; Credit; Euro Area. (search for similar items in EconPapers)
JEL-codes: C11 E32 E44 E62 H63 (search for similar items in EconPapers)
Date: 2025-09
New Economics Papers: this item is included in nep-acc, nep-dge, nep-eec, nep-eur and nep-fdg
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Persistent link: https://EconPapers.repec.org/RePEc:bdm:wpaper:2025-12

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