Testing for Balance Sheet Effects in Emerging Markets: A Non‐Crisis Setting*

Abstract

AbstractThe literature has established that emerging market economies are better insulated from large external shocks during a financial crisis when they adopt a flexible exchange rate regime. Looking at the strength of firms' balance sheets, this paper shows that the opposite holds true in non‐crisis periods. The reason is that balance sheets and thus spending decisions are less affected by external shocks under fixed regimes. This result is obtained through several theoretical and empirical methodologies that are useful for identifying balance sheet effects in a non‐crisis setting. Simulations reveal a larger (smaller) output response under flexible regimes when these effects are included (excluded). Although the transmission of foreign interest rate shocks to domestic interest rates is stronger under fixed regimes, it appears the limited effects on balance sheets generate a more muted output response.