Government Debt: A Key Role in Financial Intermediation

IMF Working Papers, March 1, 2005

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The literature on optimal fiscal policy finds that highly volatile real returns on government debt, for example through surprise inflation, have very low costs.
Policymakers are almost always very apprehensive of this option.
The paper discusses evidence concerning features of developing country financial markets that are missing in existing models, and that may suggest why this policy is considered so costly in practice.
Most importantly, domestic banks choose to be highly exposed to government debt because the alternative, private lending, is more risky under existing legal and institutional imperfections.
This exposure makes banks and their borrowers vulnerable to the government's debt policy.

Domestic banks choose high exposure to government debt.
Private lending is perceived as more risky in the presence of legal and institutional imperfections.
Bank exposure to government debt links the banking sector’s balance-sheet risk directly to government debt policy, increasing vulnerability.

The low theoretical cost of volatile real returns on government debt (e.g., surprise inflation) contrasts with policymakers’ strong aversion to such policies.
Missing features in standard models—specifically legal and institutional weaknesses in developing-country financial markets—help explain why such policies are considered costly in practice.
The interaction between government debt policy and banks’ portfolio choices suggests that government debt management affects financial stability through bank balance sheets and borrower vulnerability.

_wp0557 - Appendix I
- _wp0557 - Appendix I (Markdown version)
- _wp0557 - Appendix I (PDF)