Government Debt Held by Emerging Market Banks Poses Financial Stability Risks – IMF Blog


By Andrea Deghi, Fabio Natalucci and Mahvash S. Qureshi

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Banks’ holdings of sovereign debt hit a record high as governments spend to cushion the impact of the pandemic.

The pandemic has left banks in emerging markets to hold record levels of public debt, increasing the risks that pressures on public sector finances will threaten financial stability. The authorities must act quickly to minimize this risk.

Governments around the world have spent huge sums to help households and employers cope with the economic impact of the pandemic. Public debt rose as governments issued bonds to cover their budget deficits. The average ratio of public debt to gross domestic product – a key measure of a country’s fiscal health – hit a record 67% last year in emerging countries, according to Chapter 2 of the April 2022 report. of the IMF. Global Financial Stability Report.

Emerging market banks have provided most of this credit, taking government debt holdings as a percentage of their assets to a record 17% in 2021. In some economies, government debt accounts for a quarter of bank assets. The result: governments in emerging markets rely heavily on their banks for credit, and these banks rely heavily on government bonds as an investment that they can use as collateral to obtain central bank funding.

Economists have a name for this interdependence between banks and governments. They call it the “sovereign-bank link”, because public debt is also known as sovereign debt – a holdover from the Middle Ages, when kings and queens took out the loan.

There is cause for concern about this link. Large holdings of sovereign debt expose banks to losses if public finances are under pressure and the market value of public debt declines. This could force banks, especially those with less capital, to reduce lending to businesses and households, which would weigh on economic activity. As the economy slows and tax revenues decline, public finances could come under even more pressure, further compressing banks. Etc.

The sovereign-bank nexus could lead to a self-perpetuating negative feedback loop that could ultimately force the government into default. There is also a name for it: the “loop of destiny”. It happened in Russia in 1998 and in Argentina in 2001-02.

Today, emerging market economies are more at risk than advanced economies for two reasons. On the one hand, their growth prospects are weaker relative to the pre-pandemic trend compared to advanced economies, and governments have less fiscal firepower to support the economy. On the other hand, external financing costs have generally increased, so governments will have to pay more to borrow.

What could trigger the catastrophic loop in a country? A sharp tightening of global financial conditions, leading to higher interest rates and weaker currencies due to the normalization of monetary policy in advanced economies and heightened geopolitical tensions caused by the war in ukraine— could undermine investor confidence in the ability of emerging market governments to repay their debts. A domestic shock, such as an unexpected economic slowdown, could have the same effect.

Risk channels

So far, we have discussed one risk channel: banks’ exposure to sovereign debt. Chapter 2 of the GFSR describes two other potential channels through which risk is transmitted between the sovereign and banking sectors.

One concerns government programs, such as deposit insurance, intended to support banks in times of crisis. Pressures on public finances could damage the credibility of these guarantees, weaken investor confidence and, ultimately, damage the profitability of banks. Struggling lenders would then have to turn to government bailouts, which would further strain public sector finances.

Another channel goes through the whole economy. A blow to public finances could drive up economy-wide interest rates, hurt corporate profitability and increase credit risk for banks. This, in turn, would limit the ability of banks to lend to households and other corporate clients, dampening economic growth.

Fiscal prudence, banking resilience

All of this could put some emerging market governments in a difficult situation. On the one hand, a soft recovery means that they should continue to spend to support growth. But rising yields in advanced economies as central banks begin to normalize monetary policy could make emerging market debt less attractive and put upward pressure on borrowing costs. Fiscal prudence is therefore necessary to avoid a further intensification of the link between the State and the banks. Governments can also boost investor confidence in their own finances by developing credible plans to reduce deficits over the medium term.

It is also important to strengthen the resilience of the banking sector by maintaining loss-absorbing capital buffers. This can be done by limiting the amount of money banks distribute to shareholders in the form of dividends and share buybacks, given the heightened uncertainty about the economic outlook. In addition, asset quality reviews to guide adequate levels of capital may be needed to quantify hidden losses and identify weak banks once forbearance has ceased.

What else can policy makers do to protect themselves? Solutions will need to be tailored to each country’s circumstances, which vary widely. But basically they should:

  • To develop resolution frames for sovereign domestic debt to facilitate orderly deleveraging and restructuring when needed;
  • Improve transparency on all significant sovereign exposures of banks in order to assess the risks of possible sovereign distress;
  • Perform banking stress tests taking into account the multiple risk transmission channels in the nexus;
  • Consider options to weaken the link, such as capital surcharges on banks’ holdings of sovereign bonds above certain thresholds, once the economic recovery is more firmly established and depending on market circumstances;
  • Strengthen procedures to liquidate banks in an orderly manner if necessary and to provide liquidity in the event of a crisis;
  • Promote a deep and diverse investor base to build market resilience in countries with underdeveloped local currency bond markets.

With the right policies, emerging market economies can soften the sovereign-bank bond and reduce the risk of a financial or economic crisis.

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