Introduction and literature
Issues related to the entrenched sovereign-bank nexus, particularly home bias—banks’ holdings of sovereign domestic debt—have gained prominence during the Global Crisis in recent years as public debt was rising especially in the European periphery.1Prompted by foreign investors’ flight as well as cheap Long-Term Refinancing Operations (LTRO) funding from the ECB, many peripheral banks absorbed sizeable domestic sovereign debt both from the secondary and primary markets. The entrenched sovereign-bank nexus has raised concerns regarding the health of the banking sector as well as its potential impact on debt sustainability of the sovereign.2 It is worth noting that the recent increase in home bias is not unique to the European periphery, but has generally been observed across many advanced economies that have seen a rise in public debt (Figure 1).
Figure 1. Banks’ holding of domestic sovereign claims/total bank assets and public debt
Sources: Arslanalp and Tsuda (2012); IMF IFS; IMF WEO.
The growing literature on sovereign debt home bias and its implications for debt sustainability is relatively heterogeneous with multi-faceted consequences of home bias. Existing research points to different effects of home bias on sovereign bond yields. For example, Arslanalp and Poghosyan (2014) and Andritzky (2012), who examine the diversification angle of sovereign claims, find that an increase in the share of government debt held by domestic investors leads to an increase in sovereign bond yields in advanced markets. Similarly, Ebeke and Lu (2014) show that an increase in share of government bonds held by domestic residents has reduced bond yields in emerging markets. In contrast, Acharya and Steffen (2013) find that home bias (measured by banks’ holding of domestic sovereign debt relative to total assets) actually helped to lower spreads in the European periphery after the systemic crisis. Finally, countries with high home bias tend to have high public debt (BIS 2011) and face higher spillover risks of sovereign stress to the banks (Merler and Pisani-Ferry 2012). On a related note, a high concentration of domestic sovereign claims in banks’ balance sheets results in an increase of spillover risks of sovereign stress to banks (Acharya and others 2012).
Home bias and debt sustainability: New evidence
To examine the impact of banks’ home bias—banks’ holding of domestic sovereign debt in total assets—on advanced markets (AM) and emerging market (EM) economies, we provide answers to four questions that have implications for public debt sustainability (Asonuma et al. 2015):
- Is the cost of borrowing lower for sovereigns with higher home bias?
Yes, for both advanced and emerging markets using bond spreads and domestic bond yields, respectively. Lower spreads with high home bias reflect reduced expectation of default whenever domestic banks own a sizeable portion of domestic sovereign claims because of the anticipated high cost of sovereign default. The negative relationship between home bias and the domestic cost of borrowing is milder for emerging markets. Worsening of market sentiments tends to temper the effect of home bias on borrowing cost particularly for emerging markets. Based on a panel regression framework, Figure 2 illustrates the bond spread and home bias relationship for advanced economies.
Figure 2. Bond spreads and home bias in advanced markets
- Is a primary balance adjustment slower in sovereigns with higher home bias?
Our empirical results show that indeed sovereigns with a higher home bias are less willing to conduct fiscal consolidation. According to Figure 3, the average primary balance of countries whose home bias is above the sample median is substantially lower than that of the whole sample for a given level of lagged debt. Even if foreign investors have reduced their exposure to domestic sovereign debt markets, the presence of domestic banks ablility to absorb the domestic debt issuances can provide a significant breathing space to struggling sovereigns but this deepens the negative sovereign-bank feedback loop and could potentially delay needed fiscal adjustment.3
Figure 3. Estimated primary balance at lagged public debt of 80% of GDP
Source: Asonuma et al. (2015).
Note: Estimates of primary balance response are obtained from estimation of fiscal reaction function with a combined advanced/emerging markets sample.
- Is the level of public debt higher in countries with greater home bias?
Our panel regressions show that this is the case for both advanced and emerging markets. Figure 4 shows the positive link in a stylised scatter plot.
Figure 4. Public debt-to-GDP and home bias (average, 2005–07)
Source: Asonuma et al. (2015)
- Do sovereigns with higher home bias enter into debt distress at a higher level of public debt?
Our findings suggest a positive relationship between home bias and the level of debt at which countries are assessed to have experienced debt difficulties (Figure 5).
Figure 5. Debt distress and home bias
Sources: Baldacci and others (2001); and Cruces and Trebesch (2013).
The coincidence of high debt and high home bias likely reflects a two-way causality.
- On the one hand, governments facing difficulties delivering fiscal adjustment may induce banks through moral suasion to finance the fiscal balances by increasing their holdings of domestic sovereign debt.
- On the other hand, high demand for domestic sovereign debt by banks likely influences the conduct of discretionary fiscal policy and therefore public debt developments.
While acknowledging the presence of both effects, we aimed to substantiate the latter effect, from home bias to fiscal outcomes, by accounting for endogenity issues.4
Our main findings broadly hold in robustness checks. For instance, dropping outliers such as Greece and Japan from the country sample does not change the empirical results. The findings are also generally robust to alternative regression methodologies as well as to the use of different home bias measures. The only exception is that while we find a negative relationship between our preferred home bias measure (holdings of domestic sovereign debt relative to total assets) and advanced markets borrowing costs, the relationship is positive for the home bias measure that has total public debt as the denominator. This finding is not surprising because this measure of home bias mainly reflects the diversification angle rather than banks’ preference for sovereign debt.5
Overall, the empirical results strongly suggest that home bias matters for debt sustainability. High home bias, which in some cases is tantamount to having a captive investor base, may provide fiscal breathing space, but delays in fiscal consolidation may actually postpone problems until debt reaches dangerously high levels. The breathing space is largely the result of the favourable impact of high home bias on rollover risk which is particularly evident during crisis periods, but is not likely to yield better fiscal outcomes. The empirical analysis in this column, which examines the multi-faceted impact of home bias, provides analytical support for anecdotal evidence in this regard. For example, during the recent crisis period countries with a captive domestic investor base faced less market pressure on rollover needs, and therefore enjoyed more breathing space while attempting difficult fiscal consolidations (or during periods of lax fiscal discipline).
Disclaimer: This column summarises the main findings of an IMF working paper by Asonuma, Bakhache, and Hesse (2015). The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the authors.
This piece was originally published on Vox.
Acharya, V V, I Drechsler, and P Schnabl (2012), “A Tale of Two Overhangs: The Nexus of Financial Sector and Sovereign Credit Risks,” Banque de France Financial Stability Review, No.16, April 2012.
Acharya, V V, and S Steffen (2013), “The Greatest Carry Trade Ever? Understanding Eurozone Bank Risks,” NBER Working Paper No. 19039, May 2013.
Andritzky, J R (2012), “Government Bonds and Their Investors: What Are the Facts and Do They Matter?” IMF Working Paper 12/158, (Washington).
Arslanalp, S, and T Poghosyan (2014), “Foreign Investor Flows and Sovereign Bond Yields in Advanced Economies,” IMF Working Paper 14/27, (Washington).
Arslanalps, S, and T Tsuda (2012), “Tracking Global Demand for Advanced Economy Sovereign Debt,” IMF Working Paper 12/284, (Washington).
Asonuma, S, S Bakhache, and H Hesse (2015), “Is Banks’ Home Bias Good or Bad for Public Debt Sustainability?” IMF Working Paper 15/44, (Washington).
Bank of International Settlement (2011), “The Impact of Sovereign Credit Risk on Bank Funding Condition,” CGFS Paper, No. 43.
Baldacci, E, I Petrova, N Belhocine, G Dobrescu, and S Mazraani (2011), “Assessing Fiscal Stress,” IMF Working Paper 11/100 (Washington).
Cruces, J, and C Trebesch (2013), “Sovereign Defaults: The Price of Haircuts,” American Economic Journal: Macroeconomics, Vol. 5(3), pp. 85–117.
Ebeke, C, and Y Lu (2014), “Emerging Market Local Currency Bond Yields and Foreign Holdings in the Post-Lehman Period—A Fortune or Misfortune?” IMF Working Paper 14/29 (Washington).
IMF (2012), “Global Financial Stability Report, April (Washington).
——— (2011), “Global Financial Stability Report, September (Washington).
Merler, S, and J Pisani-Ferry (2012), “Hazardous Tango: Sovereign-Bank Interdependence and Financial Stability in the Euro area,” Banque de France Financial Stability Review, No. 16, April 2012.
1 Banks’ home bias typically denotes the preference of domestic banks for holding domestic sovereign debt instruments compared to other sovereign debt instruments. However, the two most commonly used measures of home bias in the literature (holding of domestic sovereign debt in percent of total assets, and in percent of total debt) tend to also capture other factors such as investor base diversification.
 This was one of the reasons that the 2011 European Banking Authority (EBA) stress test findings were not perceived as credible so the recapitalisation exercise forced European banks to mark-to-market all of their securities holdings (e.g., IMF 2011 and 2012).
3 In the European periphery, external market pressures and soaring sovereign yields have forced peripheral countries to start implementing some of the overdue reforms. Decisive monetary policy by the ECB has certainly helped to provide a backstop to the peripheral domestic banks, which was the predominant factor for compressing peripheral sovereign spreads.
 In particular, the empirical panel regression methodology accounts for endogeneity issues between home bias and public debt by using instruments.
 This finding that a more diversified investor base (i.e., lower home bias) is associated with lower spreads, is consistent with the literature. For example, Arslanalp and Poghosyan (2014) and Andritzky (2012) find that the diversification home bias measure and borrowing costs are positively related. However, Acharya and Steffen (2013), using the bank preference home bias measures, find a negative relationship in line with our results.