Financial stability constraints tighten sovereign debt limits

Conventional fiscal sustainability indicators often overlook fluctuating financial conditions and risk.

This paper from the Bank for International Settlements proposes a framework where sovereign borrowing costs are tied to the balance-sheet capacity of financial intermediaries.

It highlights how financial amplification can create an endogenously tighter debt limit, even without fiscal fatigue or explicit default risk.

Fiscal space becomes state-contingent, meaning identical yield shocks compress it more strongly when an economy is closer to its debt limit.

The study examines four key amplification mechanisms: the bank-sovereign nexus, "original sin redux", duration matching by long-term investors, and deleveraging in repo markets.

These mechanisms show that sovereign borrowing costs are amplified by shocks to financial intermediaries' risk-bearing capacity.

Since the Great Financial Crisis, public debt has surged globally, accompanied by significant structural shifts in the financial system.

Lending to governments has outpaced private sector financing, with a notable shift towards non-bank financial institutions (NBFIs).

These NBFIs, especially hedge funds, have expanded their global presence, holding diversified portfolios and relying heavily on repo markets for funding.

While diversifying the investor base for sovereign debt, these changes also introduce new channels of financial instability.

NBFIs' varied liquidity needs and risk management strategies can amplify procyclical dynamics, exacerbating vulnerabilities in financial markets and impacting sovereign debt stability.