Financial stability limits on fiscal space
Summary
Focus
Common indicators of fiscal sustainability such as the interest rate-growth differential (r – g) and analyses focused on long-term structural factors do not always consider the role of financial intermediation and the procyclical behaviour of liquidity and risk.
Contribution
We introduce a framework that explicitly incorporates financial intermediation and financial market dynamics into the assessment of fiscal sustainability. In this framework, financial stability concerns emerge as an additional constraint that can significantly limit fiscal space and undermine debt stability, even when conventional fiscal sustainability indicators appeared favourable before the outbreak of financial stress. Specifically, we examine four financial amplification mechanisms: the bank-sovereign nexus, original sin redux, duration matching and deleveraging in repo markets.
Findings
Four key results emerge. First, financial amplification endogenously generates a debt limit. Even without default risk or fiscal fatigue. Second, closed-form solutions show that fiscal space is tied to financial stability parameters. Fiscal space increases with deeper markets and stronger risk-bearing capacity (more intermediary equity, faster recapitalisation, less binding value-at-risk constraints, lower market volatility, shorter duration exposure) and with a stronger fiscal reaction. Thin markets and tighter risk constraints shrink fiscal space. Third, fiscal space is state-contingent. Adverse yield shocks compress fiscal space, with larger effects when the economy is closer to its debt limit. Finally, stability requires a stronger fiscal response than in standard debt sustainability analyses. Adverse shocks both raise debt and erode intermediation capacity, steepening borrowing costs. Hence, the interest rate-growth differential (r – g) is not a sufficient sustainability.
Abstract
Conventional indicators of fiscal sustainability, such as the interest rate-growth differential that focus on long-term drivers do not always incorporate fluctuating financial conditions and risk. This paper proposes an analytical framework in which sovereign borrowing costs depend on the balance-sheet capacity of financial intermediaries, where financial amplification can generate an endogenously tighter debt limit even in the absence of fiscal fatigue or explicit default risk. Fiscal space becomes state-contingent: identical yield shocks compress fiscal space more strongly when the economy is closer to its debt limit. We examine four financial amplification mechanisms: the bank-sovereign nexus, "original sin redux", duration matching, and deleveraging in repo markets.
JEL classification: E43, E44, E62, G23, H63
Keywords: fiscal sustainability, fiscal space, debt limit, financial stability, sovereign bond market, non-bank financial institutions
