Fiscal Deficits and Bond Yields: How Debt Composition Shapes Risk in EMDEs

The IMF study finds that in emerging and developing economies, higher expected fiscal deficits significantly raise domestic bond yields, especially where domestic banks hold large portions of government debt. This sovereign-bank nexus amplifies financial risks, highlighting the need for fiscal discipline and investor diversification.

In a landmark study published by the International Monetary Fund’s Fiscal Affairs Department, researchers Manabu Nose and Jeta Menkulasi explore the increasingly pivotal role of fiscal policy in shaping domestic sovereign bond yields across emerging market and developing economies (EMDEs). The study draws from a wealth of data, including IMF forecasts, Bloomberg bond yields, and investor composition statistics compiled by the World Bank and the Arslanalp-Tsuda database. As EMDEs progressively shift from external to domestic sources of debt financing, this research offers a timely and comprehensive analysis of how local bond markets interpret and respond to governments’ fiscal decisions. The findings have broad implications for fiscal strategy, financial stability, and macroeconomic management in developing countries navigating an era of tightening global liquidity.

The Rise of the Sovereign-Bank Nexus

Over the past two decades, EMDEs have witnessed a gradual, yet decisive, move toward domestic bond markets as a primary source of government financing. This transformation accelerated in the wake of the COVID-19 pandemic, when access to external funding tightened and fiscal pressures soared. Governments turned inward, relying heavily on domestic banks to absorb new issuances of sovereign bonds. As a result, domestic banks' exposure to government debt rose sharply, deepening the so-called “sovereign-bank nexus.” This closer linkage has brought short-term relief and financing flexibility, but it also amplifies systemic risks, particularly in countries with weak fiscal anchors or fragile banking sectors. When public finances deteriorate, the stress is transmitted directly to bank balance sheets, raising the specter of a "doom loop" between sovereign and financial sector distress.

Fiscal Expectations Drive Domestic Borrowing Costs

The heart of the paper lies in its econometric analysis, which employs Local Projection (LP) methods to estimate how expectations of fiscal deficits affect domestic bond yields. Using data from 75 EMDEs between 2010 and 2023, the authors find that a one percentage point increase in the expected primary deficit (projected four years into the future) leads to a persistent rise in 10-year domestic bond yields, peaking at around 36 basis points over a 2.5-year horizon. This result reflects markets’ forward-looking nature, investors are pricing in fiscal slippage long before deficits materialize. The sensitivity of yields has increased in the post-COVID period, reflecting greater scrutiny of fiscal positions amid tighter global financial conditions. Importantly, these results remain robust even when controlling for other macroeconomic variables such as inflation, growth, exchange rate expectations, sovereign credit ratings, and global financial indicators like the VIX.

Debt Holder Composition Matters More Than Ever

One of the paper’s most important contributions is its nuanced examination of how debt holder composition moderates the relationship between fiscal policy and borrowing costs. The study finds that domestic bond yields are significantly more responsive to fiscal loosening in countries where domestic banks hold a larger share of government debt. In economies with a pronounced sovereign-bank nexus, the impact of a one percentage point increase in expected fiscal deficits can reach up to 50 basis points, nearly double the baseline effect. Conversely, in countries where debt is more evenly distributed across foreign investors or domestic non-bank financial institutions, the market response is notably milder. This dynamic reflects both risk perception and the degree to which domestic banks act as captive financiers of the state. By comparison, external bond spreads show a weaker correlation with domestic fiscal variables, responding more to global risk factors like U.S. interest rates and investor sentiment.

The Hidden Risks of Financing Concentration

To further test their hypotheses, the authors conduct a counterfactual sensitivity analysis that isolates how different types of investors—domestic banks, domestic non-banks, and foreign non-banks respond to fiscal expansion. The results confirm that an increased reliance on domestic banks to finance deficits leads to greater yield sensitivity. Interestingly, while foreign investors do participate actively in some EMDE bond markets, their impact on yield responses to fiscal policy is less pronounced. However, this does not mean they pose no risk. The paper notes that abrupt shifts in foreign investor sentiment, as witnessed during the pandemic, can lead to destabilizing outflows. The upshot is that overreliance on any one investor class, particularly domestic banks, heightens vulnerability not just to fiscal shocks but also to financial contagion and credit market disruptions.

Policy Lessons for a New Era of Sovereign Financing

The study throws light on several key policy recommendations for EMDEs. First and foremost, fiscal credibility remains paramount. Countries with high projected deficits must recognize that markets will increasingly price in fiscal risks through higher borrowing costs, especially in domestic markets. Second, the paper underscores the importance of avoiding excessive reliance on domestic banks for deficit financing. While convenient in the short term, this practice exposes the financial sector to sovereign shocks and constrains the government’s ability to implement countercyclical policies during downturns. Third, diversifying the investor base both domestically and internationally can help buffer against market volatility and reduce systemic risk. Finally, enhanced regulation and supervision of financial institutions’ sovereign exposures, alongside the development of robust debt management strategies, are essential to avoid the dangerous feedback loops that threaten macro-financial stability. This study serves as a timely reminder that sound fiscal policy is not just about keeping deficits low; it’s about preserving trust in public debt markets that have become more sophisticated, more domestic, and more reactive than ever before.