The Return of Expansionary Austerity : Firms' Investment Response to Fiscal Adjustments in Emerging Markets

In emerging markets, unexpected public expenditure reductions increase firm-level investment, which quickly surpasses pre-shock levels after a temporary contraction, owing to a decline in financing costs. Investment’s recovery is facilitated by fiscal space, exchange rate flexibility, and public spending predictability. Also, adjustment composition matters: reductions in public consumption (vis-a-vis public investment) yield larger private investment contractions on impact but result in stronger recoveries. Exploiting firm-level heterogeneity we show that investment’s expansion is stronger in the tradable-sector, in larger, and in less indebted firms. We provide evidence that the long-run benefits of fiscal shocks to firm-level activity outweigh their short-run costs