The International Monetary Fund (IMF) has raised concerns over the increasing exposure of commercial banks to domestic sovereign debt in Emerging Market and Developing Economies (EMDEs).
In its latest report, "Fiscal Determinants of Domestic Sovereign Bond Yields in EMDEs," the IMF highlighted how domestic bonds have become a primary source of government financing, with banks playing a key role in absorbing this debt.
Banks' Growing Role in Sovereign Debt
According to the IMF, banks' holdings of government bonds have surged since the global financial crisis, accelerating further after COVID-19. This trend, known as the sovereign-bank nexus, increases financial sector risks and affects borrowing costs.
Key Risks Identified by IMF
Higher Borrowing Costs: Increased reliance on banks for deficit financing could push up domestic bond yields, especially in countries with high debt levels.
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Fiscal Policy Impact: Loose fiscal policies have a stronger effect on bond yields due to banks' deep involvement in sovereign debt.
Credit Risk Spillover: Banks' exposure to government debt could weaken their ability to lend to businesses and households, slowing economic growth and raising sovereign credit risk.
Sovereign-Bank Nexus Deepens Post-Pandemic
The IMF noted that during the COVID-19 crisis, many EMDEs relied on domestic debt issuances to meet financing needs, with commercial banks absorbing a significant portion. This shift has made bond yields increasingly sensitive to fiscal policies and heightened the risks of financial instability.
IMF's Warning to EMDEs
The Fund cautioned that as domestic debt markets expand, governments must carefully manage fiscal policies to prevent rising borrowing costs and systemic financial risks.
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