Government Debt: A Key Role in Financial Intermediation

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The literature on optimal fiscal policy finds that highly volatile real returns on government debt, for example through surprise inflation, have very low costs. However, 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.

Public debt and financial stability: The case of economic community and monetary union of central Africa (EMCCA)

“…The results also show that, in excess of 94.1 USD (regime 2), public debt reduces the bad debts (-0.4291) of banks in the EMCCA zone. This is in line with the results of Kumhof and Tanner (2005) and Ilgün (2010) that public debt contributes to the maintenance of financial stability. Indeed, in this regime 2, the EMCCA significantly states the increase in their oil revenues, which has the effect of strengthening the confidence of the banks with regard to government bonds.…”

“…This part of the literature reveals two points of view. The first, defended in particular by Kumhof and Tanner (2005) and Ilgün (2010), argues that the public debt strengthens the stability of the financial sector through the security, high liquidity and steady flow of profits offered by the bonds State. The second point of view, supported by Houben et al (2014), Ilgün (2016) and Janda and Kravtsov (2017), shows that a high public debt currency, would be a source of financial instability.…”

Sovereign defaults and liquidity crises

“…through cash deposits or credit lines). In particular, empirical evidence suggests that government bonds typically constitute a large fraction of domestic banks' assets with higher figures corresponding to developing countries and, among this group, to countries with weak creditors' rights protection (Reinhart et al, 2003;and Kumhof and Tanner, 2005). This observation, however, is not inconsistent with the model.…”

Sovereign defaults and banking crises

“…Banks are highly exposed to sovereign debt. Kumhof and Tanner (2005) define the "exposure ratio" of a given country as the financial institutions' net credit to the government divided by the financial institutions' net total assets. Using IMF data for the period 1998-2002 they report an average exposure ratio of 22% for all countries, 24% for developing economies, and 16% for advanced economies.…”