IMF Working Papers

Domestic sovereign bonds have become a growing source of government financing in Emerging Market and Developing Economies (EMDEs). This paper investigates the role of fiscal policies in determining domestic bond yields, and how this relationship varies depending on the debt structure. Specifically, the analysis highlights the interaction of fiscal policy with banking sector leverage and foreign investor holdings for government debt. 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, with larger effects observed during the COVID-19 pandemic. This contrasts with external bond spreads which are more sensitive to external and global risk factors. The greater the reliance on domestic banks for deficit financing, the stronger the impact of loose fiscal policy on domestic bond yields. The shift in domestic debt financing towards domestic banks after the pandemic implies that sovereign yields have been increasingly interlinked with domestic banks’ investment behavior implying potential financial sector risks in major EMDEs.