Fiscal Determinants of Domestic Sovereign Bond Yields in Emerging Market and Developing Economies

IMF Working Papers, March 28, 2025

Source details

Canonical URL: Fiscal Determinants of Domestic Sovereign Bond Yields in Emerging Market and Developing Economies

Domestic sovereign bonds are an increasing source of government financing in Emerging Market and Developing Economies (EMDEs).
The paper investigates how fiscal policies determine domestic bond yields and how this relationship varies with debt structure and holder composition.
Analysis emphasizes interactions of fiscal policy with banking sector leverage and foreign investor holdings for government debt.
Contrast drawn between domestic bond yields and external bond spreads: domestic yields respond to fiscal factors and domestic financing structure, while external spreads are more sensitive to external and global risk factors.

A 1 percentage point increase in expected primary deficits results in a persistent increase in 10-year domestic bond yield by around 36 basis points over 2.5 years.
Effects of expected primary deficits on domestic yields were larger during the COVID-19 pandemic.
The greater the reliance on domestic banks for deficit financing, the stronger the impact of loose fiscal policy on domestic bond yields.
Post-pandemic shift in domestic debt financing toward domestic banks implies sovereign yields have become increasingly interlinked with domestic banks’ investment behavior, implying potential financial sector risks in major EMDEs.

Interaction channels highlighted:
- Banking sector leverage amplifies the effect of fiscal loosening on domestic yields.
- Foreign investor holdings of government debt modulate sensitivity of yields to fiscal policy.
Comparison with external debt markets:
- Domestic bond yields: more responsive to domestic fiscal dynamics and domestic financing structure.
- External bond spreads: more sensitive to external and global risk factors.

Increased reliance on domestic banks for deficit financing raises sovereign-bank nexus risks ("doom-loop") as sovereign yields become linked to banks’ investment behavior.
Fiscal discipline matters for domestic borrowing costs: persistent larger deficits materially raise long-term domestic yields.
Monitoring of debt holder composition and banking sector leverage is important for assessing sovereign yield vulnerability and financial sector risk in EMDEs.