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This paper aims at explaining why the public spending multiplier is generally low, even close to zero, in emerging economies (EMEs). We claim that this can be related to the foreign currency denominated debt borne by private agents. Indeed, according to a recent literature, the real exchange rate can depreciate following an increase in public spending. In this case, the debt burden denominated in foreign currency increases. Thus, the domestic firms' balance sheet structure deteriorates, which raises their external finance premium and pushes private investment down. Finally, this may offset the stimulating impact of the initial public spending shock. In this paper, we first show that this explanation is empirically valid: the impulse response functions from a PCH-VAR indicate that the the higher the share of the external debt denominated in foreign currency, the lower the public spending multiplier. Then, we demonstrate that such an explanation and its underlying mechanisms are theoretically valid in a two-country DSGE model with incomplete and imperfect international financial markets, sticky prices, financial frictions and external indebtedness.
