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

TheSovereign-BankNexusinEmergingMarketsintheWakeoftheCOVID-19Pandemic PreparedbyAndreaDeghi,SalihFendoglu,TaraIyer,HamidRezaTabarraei,YizhiXuandMustafaY.Yenice WP/22/223 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2022 NOV ©2022InternationalMonetaryFundWP/22/223 IMFWorkingPaper MonetaryandCapitalMarketsDepartment TheSovereign-BankNexusinEmergingMarketsintheWakeoftheCOVID-19Pandemic PreparedbyAndreaDeghi,SalihFendoglu,TaraIyer,HamidRezaTabarraei,YizhiXu,andMustafaYasinYenice* AuthorizedfordistributionbyMahvashQureshiNovember2022 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:TheCOVID-19pandemichasbroughttherelationshipbetweensovereignsandbanks—theso-calledsovereign-banknexus—inemergingmarketeconomiestotheforeasbankholdingsofdomesticsovereigndebthavesurged.Thispaperexaminestheempiricalrelevanceofthisnexustoassesshowitcouldamplifymacro-financialstabilityrisks.Thefindingsshowthatanincreaseinsovereigncreditriskcanadverselyaffectbanks’balancesheetsandcreditsupply,especiallyincountrieswithless-well-capitalizedbankingsystems.Sovereigndistresscanalsoimpactbanksindirectlythroughthenonfinancialcorporatesectorbyconstrainingtheirfundingandreducingtheircapitalexpenditure.Notably,theeffectsonbanksandcorporatesarestronglynonlinearinthesizeofthesovereigndistress. JELClassificationNumbers: E44,F34,F65,G21 Keywords: Sovereign-banknexus,emergingmarkets;financialstability,sovereignrisk,COVID-19,bankingsector,corporateinvestment Author’sE-MailAddress: ADeghi@imf.org;SFendoglu@imf.org;HTabarraei@imf.org;TIyer@imf.org;YXu@imf.org;MYenice@imf.org *TheauthorsareverygratefulforcommentsbyViralAcharya,TobiasAdrian,FabioNatalucci,MahvashQureshi,JérômeVandenbusscheandseminarparticipantsattheInternationalMonetaryFund,theAssociationofSupervisorsofBanksoftheAmericas(ASBA),CentralBankofColombia,YaleFinancialStabilityProgram,TheHongKongMonetaryAuthority,TheMonetaryAuthorityofSingapore,andTheJointViennaInstitute.OksanaKhadarinaandDmitryYakovlevprovidedoutstandingresearchassistance. WORKINGPAPERS TheSovereign-BankNexusinEmergingMarketsintheWakeoftheCOVID-19Pandemic PreparedbyAndreaDeghi,SalihFendoglu,TaraIyer,HamidRezaTabarraei,YizhiXu,andMustafaYasinYenice Contents I.INTRODUCTION4 II.CONCEPTUALFRAMEWORK5 III.DEVELOPMENTSINTHESOVEREIGN-BANKNEXUSINEMERGINGMARKETS:SOMESTYLIZEDFACTS8 IV.EVALUATINGTHESTRENGTHOFTHENEXUS10 V.ANEMPIRICALEVALUATIONOFTHETRANSMISSIONMECHANISMS12 A.SovereignExposureChannel12 B.SafetyNetChannel16 C.MacroeconomicChannel21 VI.CONCLUSIONS26REFERENCES26 FIGURES Figure1KeyChannelsoftheSovereign-BankAdverseFeedbackLoop6Figure2.DevelopmentsinEmergingMarketPublicDebtandBanks’SovereignExposures9Figure3.TransmissionofRisksthroughtheSovereign-BankNexus:StrengthoftheMainChannelsacrossEmergingMarkets11Figure4.TransmissionofSovereignRiskthroughtheExposureChannel15Figure5.StylizedFactsonBankSupportRatingFloorinEmergingMarkets17Figure6.TheEffectofSafetyNetsonBanks’ReturnsfollowingSovereignDistressinEMs19Figure7.AdditionalRobustnessAnalysisontheEffectofSafetyNetonBanks’Returns20Figure8.Banks’Risk-TakingandMoralHazardduringSovereignDistress21Figure9.SovereignDowngradesandBoundvs.UnboundFirmsinEmergingMarkets23Figure10.SovereignDowngradesImpactonBoundvs.UnboundFirmsinEMs24FigureA.II.1TheImpactofaTighteningofGlobalFinancialConditionsonSovereignandBank49FigureA.III.1MoralSuasionandRiskShifting:ThresholdEffects51 TABLES Table1.ExposureChannel:TheEffectofSovereignDistressonBankEquityatDifferentDistressThresholds29 Table2.ExposureChannel:ValuationEffectonFiscalDebtandKeyBankOutcomeVariables31Table3.ExposureChannel:Theeffectofdebtrolloverrisksonkeybankoutcomevariables31Table4.SafetyNetChannel:TheEffectonBanks’EquityAbnormalReturns32Table5:SafetyNetChannel:TheEffectonBanks’Risk-TakingActivity34Table6.MacroeconomicChannel:BaselineRegressions.Changeininvestmentratioanddebt35 Table7.MacroeconomicChannel:CorporateInvestmentFollowingaSovereignDowngradeat36Table8.MacroeconomicChannel:PlaceboTestsBaselineRegressions38Table9:MacroeconomicChannel:IndirectImpactofSovereignDowngradeonBanksthroughFirms38TableA.I.1ListofCountriesintheEmergingMarketsSample40TableA.I.2.SovereignStress/DefaultEpisodesCoverage41TableA.I.3.DataDescriptionandSources42TableA.I.4SummaryStatistics44TableA.II.1.Numberofdailychangesinvolatilityregimes47TableA.III.1.RegressionResultsfortheDriversofBank’sSovereignDebtHoldings50 ANNEXES AnnexI.DataDescriptionandSummaryStatistics39AnnexII.StructuralModelEstimationandModelExtensions45AnnexIII.ExaminingthePresenceofMoralSuasionandRisk-Shifting48 I.Introduction PublicdebtinemergingmarketeconomieshassurgedinthewakeoftheCOVID-19pandemicaseco