**3.2 The sovereign-Bank nexus10**

The pandemic has left emerging-market banks holding record levels of government debt, increasing the odds that pressures on public-sector finances could threaten financial stability. According to Chapter 2 of the IMF's April 2022 Global Financial Stability Report [12], the average ratio of public debt to gross domestic product rose to a record 67% last year in emerging market countries. Emerging-market 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. As a 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.

This interdependence carries the seeds of financial instability. 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

<sup>9</sup> By contrast economic activity in some EZ countries is still low.

<sup>10</sup> This subsection draws on chapter 1 of the April 2022 Global Financial Stability Report [12] and on Ref. [13].

### *Current Challenges to World Financial Stability: To What Extent is the Past a Guide for the… DOI: http://dx.doi.org/10.5772/intechopen.107432*

banks—especially those with less capital—to curtail lending to companies and households, weighing on economic activity. As the economy slows and tax revenues shrink, government finances may come under even more pressure, further squeezing banks. The sovereign-bank nexus could lead to a self-reinforcing adverse feedback loop that ultimately could force the government into default triggering a, so-called, "doom loop" between domestic banks and government debt. Such a loop reinforced the 1998 Russian crisis and the 2001–2002 Argentinian crisis.

Emerging-market (EM) economies are at greater risk to experience this "doom loop" 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 of EM have generally risen, so governments have to pay more to borrow. The recent sharp tightening of global financial conditions—resulting in higher interest rates and weaker currencies on the back of monetary policy normalization in advanced economies and intensifying geopolitical tensions caused by the war in Ukraine—could undermine investor confidence in the ability of EM governments to repay debts. A domestic shock, such as an unexpected economic slowdown, could have the same effect.

#### **3.3 Strains on public finances in emerging markets**

More generally, strains on public finance in EM with limited access to credit constitute another vulnerability. For example, Government programs, such as deposit insurance, intended to support banks in times of stress may trigger systemic financial fears. 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.

Another risk channel works through the broader economy. 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 and making the economy more vulnerable to unexpected shocks. Further details appear in chapter 2 of the April 2022 Global Financial Stability Report.
