Emerging Market Banks’ Government Debt Holdings Pose Financial Stability Risks – IMF Blog

By Andrea Deghi, Fabio Natalucci and Mahvash S. Qureshi

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

The pandemic has left emerging market banks with record levels of public debt, raising the likelihood that pressures on public sector finances could threaten financial stability. Authorities must act quickly to minimize that risk.

Governments around the world have spent aggressively to help households and employers weather the economic impact of the pandemic. Public debt has increased as governments have 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, rose to a record 67% last year in emerging market countries, according to Chapter 2 of the Financial Stability Report. IMF April 2022 Global.

Emerging market banks have provided most of that credit, driving government debt holdings as a percentage of assets to a record 17% in 2021. In some economies, government debt amounts to a quarter of bank assets. . The result: Emerging market governments 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 nexus,” because government debt is also known as sovereign debt, a holdover from the Middle Ages, when kings and queens borrowed.

There are reasons to be concerned about this nexus. Large sovereign debt holdings expose banks to losses if public finances come under pressure and the market value of public debt declines. That could force banks, especially those with less capital, to cut lending to businesses and households, hurting economic activity. As the economy slows and tax revenues shrink, government finances could come under even greater pressure, further hurting banks. And so.

The sovereign-bank nexus could lead to a self-reinforcing adverse feedback loop that could ultimately force the government to default. There’s a name for that, too: the “fatal loop.” It happened in Russia in 1998 and in Argentina in 2001-02.

Now emerging market economies are at greater risk than advanced economies for two reasons. For one thing, their growth prospects are weaker relative to the pre-pandemic trend compared to advanced economies, and governments have less fiscal power 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 vicious circle in a country? A sharp tightening of global financial conditions, resulting in higher interest rates and weaker currencies due to the normalization of monetary policy in advanced economies and the intensification of geopolitical tensions caused by the war in Ukraine, could undermine the investor confidence in the ability of emerging market governments to repay debts. A domestic shock, such as an unexpected economic slowdown, could have the same effect.

risk channels

So far, we have discussed one channel of risk: 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 relates to government programs, such as deposit insurance, designed to support banks in times of stress. Strains in government finances could damage the credibility of those guarantees, undermine investor confidence and ultimately hurt banks’ profitability. Troubled lenders would then have to resort to government bailouts, putting further pressure on public sector finances.

Another channel works through the economy in general. A hit to public finances could push up interest rates across the economy, hurting corporate profitability and increasing credit risk for banks. That, in turn, would limit banks’ ability to lend to households and other corporate customers, slowing economic growth.

Fiscal prudence, banking resilience

All of this could put some emerging market governments in a tough spot. On the one hand, a slow recovery means they must keep spending to support growth. But rising yields in advanced economies as central banks start to normalize monetary policy could make emerging market debt less attractive and push up borrowing costs. Therefore, fiscal prudence is needed to avoid a further intensification of the sovereign-bank nexus. Governments can also bolster investors’ 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 preserving loss-absorbing capital buffers. This can be done by limiting the amount of money that banks distribute to shareholders through dividends and share buybacks, given the increased uncertainty about the economic outlook. In addition, asset quality reviews to guide appropriate levels of capital may be necessary to quantify hidden losses and identify weak banks once forbearance has ended.

What else can politicians do to protect themselves? Solutions will need to be tailored to country circumstances, which vary widely. But generally speaking, they should:

• Develop resolution frameworks for sovereign domestic debt to facilitate orderly deleveraging and restructuring if necessary;
• Enhance transparency on all banks’ material sovereign exposures to assess the risks of potential sovereign distress;
• Carry out banking stress tests taking into account the multiple risk transmission channels in the nexus;
• Consider options to weaken the nexus, such as capital surcharges on banks’ sovereign bond holdings 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 a crisis;
• Promote a deep and diversified investor base to strengthen market resilience in countries with underdeveloped local currency bond markets.

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