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Government debt poses financial stability risks, warns IMF

Clara Nwachukwu

The International Monetary Fund (IMF), says the pandemic has left emerging-market banks holding record levels of government debt, thereby increasing the odds that pressures on public-sector finances could threaten financial stability.

Authorities should act quickly to minimize that risk, the Fund advised yesterday in its latest IMFBlog.

The Blog titled: “Emerging-Market Banks’ Government Debt Holdings Pose Financial Stability Risks,” was written by Andrea Deghi, Fabio Natalucci, and Mahvash S. Qureshi.

The writers noted that Governments around the world have spent aggressively to help households and employers weather the economic impact of the pandemic.

As a result, public debt has mounted 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 IMF’s April 2022 Global Financial Stability Report (GFSR).

The Blog is particularly worried about the emerging markets, including Nigeria, where it said: “banks have provided most of that credit, driving holdings of government debt as a percentage of their 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 for securing funding from the central bank,” it added.

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.

Banks, governments’ interdependence

The Blog noted that interdependence between banks and governments also called the “sovereign-bank nexus,” is worrisome because “Large holdings of sovereign debt expose banks to losses if government finances come under pressure and the market value of government debt declines.

“That could force banks—especially those with less capital—to curtail lending to companies and households, weighing on economic activity.

“As the economy slows and tax revenues shrivel, government finances could come under even more pressure, further squeezing banks.”

It also warned that the sovereign-bank nexus could lead to a self-reinforcing adverse feedback loop—the “doom loop” that could force the government into default, as was the case in Russia in 1998, and in Argentina in 2001-02.

Specifically, the Blog said emerging-market economies are at greater risk than advanced economies for two reasons.

First, their growth prospects are weaker relative to the pre-pandemic trend compared with advanced economies, and governments have less fiscal firepower to support the economy. Second, external financing costs have generally risen, so governments will have to pay more to borrow.

The doom loop in a country would therefore lead to a sharp tightening of global financial conditions—resulting in higher interest rates and weaker currencies on the back of monetary policy normalization in advanced economies.

Also, intensifying geopolitical tensions caused by the war in Ukraine—could undermine investor confidence in the ability of emerging-market governments to repay debts.

This is just as a domestic shock, such as an unexpected economic slowdown, could have the same effect.

A blow to public finances could push economy-wide interest rates higher, hurting corporate profitability and increasing credit risk for banks. That in turn would limit banks’ ability to lend to households and other corporate customers, curbing economic growth.

Risk channels

The IMFBlog also identified other risk channels banks’ exposure to sovereign debt relating to government programs, such as deposit insurance, intended to support banks in times of stress.

“Strains on government finances could hurt the credibility of those guarantees, weaken investor confidence, and ultimately hurt banks’ profitability. Troubled lenders would then have to turn to government bailouts, further straining public-sector finances.

“A blow to public finances could push economy-wide interest rates higher, hurting corporate profitability and increasing credit risk for banks. That in turn would limit banks’ ability to lend to households and other corporate customers, curbing economic growth.

Fiscal prudence, bank resilience

To reduce the risks of a financial or economic crisis, the Blog called for fiscal prudence with governments drawing up credible plans to narrow deficits over the medium term.

Risks can also be mitigated by strengthening banking-sector resilience by conserving loss-absorbing capital buffers through limiting the amount of money that banks distribute to shareholders through dividends and stock buybacks, given heightened uncertainty about the economic outlook.

“In addition, asset quality reviews to guide adequate levels of capital may be necessary to quantify hidden losses and identify weak banks once forbearance has ceased,” it added.

On broader terms, governments should also:

  • Develop resolution frameworks for sovereign domestic debt to facilitate orderly deleveraging and restructuring in case they are needed;
  • Improve transparency on all banks’ material sovereign exposures to assess the risks from possible sovereign distress;
  • Conduct bank stress tests by taking into account the multiple channels of risk transmission in the nexus;
  • Consider options to weaken the nexus—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 wind down banks in an orderly fashion if needed 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.
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