Growth Effects of Corporate Balance Sheet Adjustments in the EU

Abstract: This paper investigates the impact of active balance sheet adjustments in the non-financial corporate sector on economic growth in the EU. We jointly model firms’ ability to reduce their balance sheet imbalances and a growth equation in an instrumental variables (IV) panel context. This enables us to explicitly consider the contemporaneous interaction between corporate balance sheet adjustment and growth, which can otherwise bias inference. Our main findings inter alia suggest that periods of active corporate deleveraging are associated on average with lower output growth compared to periods when no adjustment takes place. Moreover, a decline in corporate debt overhang supports output growth. Model-based simulations are in line with these findings.