The Sovereign-Bank Nexus in Emerging Markets in the Wake of the COVID-19 Pandemic

The Sovereign-B ank Nexus in Emerging Markets in the Wake of the COVID-19 Pandemic Prepared by Andrea Deghi, Salih Fendoglu, Tara Iyer, Hamid Reza Tabarraei, Yizhi Xu and Mustafa Y. Yenice WP/22/223 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2022 NOV *The authors are very grateful for comments by Viral Acharya, Tobias Adrian, Fabio Natalucci, Mahvash Qureshi, JérômeVandenbussche and seminar participants at the International Monetary Fund, the Association of Supervisors of Banks of theAmericas (ASBA), Central Bank of Colombia, Yale Financial Stability Program, The Hong Kong Monetary Authority, The Monetary Authority of Singapore, and The Joint Vienna Institute. Oksana Khadarina and Dmitry Yakovlev provided outstanding research assistance. © 2022 International Monetary Fund WP/22/223IMF Working Paper Monetary and Capital Markets Department The Sovereign-Bank Nexus in Emerging Markets in the Wake of the COVID-19 Pandemic Prepared by Andrea Deghi, Salih Fendoglu, Tara Iyer, Hamid Reza Tabarraei, Yizhi Xu, and Mustafa Yasin Yenice* Authorized for distribution by Mahvash Qureshi November 2022 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: The COVID-19 pandemic has brought the relationship between sovereigns and banks—the so-called sovereign-bank nexus—in emerging market economies to the fore as bank holdings of domestic sovereign debt have surged. This paper examines the empirical relevance of this nexus to assess how it could amplify macro-financial stability risks. The findings show that an increase in sovereign credit risk can adversely affect banks’ balance sheets and credit supply, especially in countries with less-well-capitalized banking systems. Sovereign distress can also impact banks indirectly through the nonfinancial corporate sector by constraining their funding and reducing their capital expenditure. Notably, the effects on banks and corporates are strongly nonlinear in the size of the sovereign distress. JEL Classification Numbers: E44, F34, F65, G21 Keywords: Sovereign-bank nexus, emerging markets; financial stability, sovereign risk, COVID-19, banking sector, corporate investment Author’s E-Mail Address: ADeghi@imf.org; SFendoglu@imf.org; HTabarraei@imf.org; TIyer@imf.org; YXu@imf.org; MYenice@imf.org WORKING PAPERS The Sovereign-Bank Nexus in Emerging Markets in the Wake of the COVID-19 Pandemic Prepared by Andrea Deghi, Salih Fendoglu, Tara Iyer, Hamid Reza Tabarraei, Yizhi Xu, and Mustafa Yasin Yenice IMF WORKING PAPERS The Sovereign-Bank Nexus in Emerging Markets in the Wake of the COVID-19 Pandemic INTERNATIONAL MONETARY FUND 2 Contents I. INTRODUCTION ___________________________________________________________________________________ 4 II. CONCEPTUAL FRAMEWORK _____________________________________________________________________ 5 III. DEVELOPMENTS IN THE SOVEREIGN-BANK NEXUS IN EMERGING MARKETS: SOME STYLIZED FACTS _____________________________________________________________________________________ 8 IV. EVALUATING THE STRENGTH OF THE NEXUS ________________________________________________ 10 V. AN EMPIRICAL EVALUATION OF THE TRANSMISSION MECHANISMS ____________________ 12 A. Sovereign Exposure Channel _____________________________________________________________________ 12 B. Safety Net Channel _______________________________________________________________________________ 16 C. Macroeconomic Channel _________________________________________________________________________ 21 VI. CONCLUSIONS ________________________________________________________________________________ 26 REFERENCES _______________________________________________________________________________________ 26 FIGURES Figure 1 Key Channels of the Sovereign-Bank Adverse Feedback Loop ___________________________________________ 6 Figure 2. Developments in Emerging Market Public Debt and Banks’ Sovereign Exposures_______________________ 9 Figure 3. Transmission of Risks through the Sovereign-Bank Nexus: Strength of the Main Channels across Emerging Markets _______________________________________________________________________________________________ 11 Figure 4. Transmission of Sovereign Risk through the Exposure Channel _______________________________________ 15 Figure 5. Stylized Facts on Bank Support Rating Floor in Emerging Markets ____________________________________ 17 Figure 6. The Effect of Safety Nets on Banks’ Returns following Sovereign Distress in EMs _____________________ 19 Figure 7. Additional Robustness An