The International Monetary Fund (IMF) has raised serious concerns over banks’ rising exposure to domestic bond markets.
In a report: “Fiscal Determinants of Domestic Sovereign Bond Yields in Emerging Market and Developing Economies”, the Fund said domestic sovereign bonds have become a growing source of government financing in Emerging Market and Developing Economies (EMDEs), with banks playing key roles in the investments.
The Fund disclosed that commercial banks’ exposure to their government debt has continued to increase since the global financial crisis and accelerated after the COVID-19, strengthening sovereign-bank nexus.
The Fund, however, warned that an increase in domestic banks’ holdings of domestic sovereign debt after the global financial crisis in advanced and emerging market economies could raise the cost of borrowing depending on the level of debt and market sentiment.
The Fund said that over the past two decades, emerging market and development economies have increasingly turned to domestic sources of financing.
“This trend reflects the significant development of local debt markets, which provide a viable alternative to external financing and mitigate exposure to currency risk. At the same time, there has been a notable shift in the creditor composition of domestic debt, with a concentration of government debt held by domestic banks, thereby intensifying the sovereign-bank nexus,” the Fund said.
According to the IMF, the COVID-19 pandemic further accentuated these trends, as many EMDEs encountered substantial financing needs that were met through a marked increase in domestic debt issuances, offering a breathing space during a period characterised by tight external financing conditions.
“These issuances were predominantly absorbed by domestic banks and foreign investors. Moving forward, as domestic debt markets continue to expand, it becomes critical to comprehend the determinants of domestic borrowing costs as well as any emerging risks,” it added.
The IMF specifically, highlighted the interaction of fiscal policy with banking sector leverage and foreign investor holdings for government debt.
It said: “The greater the reliance on domestic banks for deficit financing, the stronger the impact of loose fiscal policy on domestic bond yields. The shift in domestic debt financing towards domestic banks after the pandemic implies that sovereign yields have been increasingly interlinked with domestic banks’ investment behavior implying potential financial sector risks in major EMDEs”.
The Fund disclosed that bond yields in EMDEs are becoming increasingly sensitive to fiscal fundamentals, reflecting increased domestic banks’ exposure to public debt as well as gradually strengthened local currency bond markets.
It warned against spillovers of banks’ credit risk to the sovereign through the direct banks’ exposure to the sovereign by holding government debt, the provision of government guarantees to cover banks’ losses, and indirect risk transmission through diminished bank lending to households and corporations, undermining growth and raising fiscal and sovereign credit risk.
Overall, it said that local debt markets are able to discern default risk, and hence, expectations regarding fiscal deficits play a significant role in determining local bond yields. In cases of elevated sovereign bank nexus, this relationship is amplified.
The Fund said it used IMF’s Monetary and Financial Statistics (MFS) database to analyze the exposure of commercial banks, Central Banks, and other financial corporations (OFC) to the public sector.
