A Sovereign Debt Composition Perspective on The Great Financial Crisis, the Taper Tantrum and COVID-19
By Serkan Arslanalp (IMF), Takahiro Tsuda (World Bank), and Daniel Yang (Stanford)
As we continue to grapple with the economic consequences of COVID-19, global public debthas surpassed its highest burden in recorded history. With governments providing the necessary fiscal support for pandemic relief and recovery, global public debt burdens rose to 97 percent of GDP in 2020, and are expected to stabilize at around 99 percent in 2021. At the same time, interest rates are at historic lows. In advanced economies in particular, central banks have lowered interest rates to their effective zero lower bound.
In this unprecedented environment of coupled extremes, understanding the many possible sovereign debt developments requires knowing the composition of the debt ownership base. Shifts in ownership can affect governments’ borrowing costs, refinancing risks, and sovereign-bank linkages that could potentially threaten financial stability. Way back in the Asia Crisis of 1997-98, understanding the investor base was central to appreciating how contagion could spread to Russia and then South America.
Using a global comparable dataset on the investor holdings of sovereign debt compiled at the IMF (see links to the dataset here and here), we can compare the impact of the Great Financial Crisis, the Taper Tantrum, and COVID-19 on the sovereign debt investor base. The dataset is uniquely suited to analyzing investor base dynamics during crises due to its large cross-section and time series that covers many of the generally rare crisis events in the past 30 years. It provides a consistent debt and residency-based investor definition for 180 countries from 1989 to 2020 annually (where feasible) and from 2004 to 2020 quarterly.
Since the onset of the pandemic, central banks in advanced economies have emerged as a major creditor. This pattern has in turn created more fiscal space for governments, where central banks largely financed fiscal deficits. See Figure 1 showing some selected countries.
Some countries have gone further to adopt yield curve control to impose interest rate caps on long-term government bonds. With low yields on government bonds, there may be little to no immediate fiscal cost for public debt, creating greater latitude for fiscal policy. Yet the history of attempts to control price and quantity have a chequered past. At the same time, the increasing dominance of the central bank in the sovereign debt market may reduce liquidity and complicate the price discovery function.
While central banks may be less active in emerging market economies (EMs), examining the ownership base composition can provide equally important insights. Comparing to the previous stress periods of the Global Financial Crisis (GFC) and the Taper Tantrum, COVID-19 shares a similar pattern whereby most EMs experienced substantial outflows during the early stage of each crisis, followed by resumed inflows during the late stage.
However, there are divergent patterns as well: while the GFC induced outflows of various sizes across the board, the effect of the Taper Tantrum was less significant.
More heterogeneity of flows can be seen for COVID-19. The fact that COVID-19 induced various degrees of disruptions, which led EMs to pursue different reactive fiscal and monetary policies, may in part explain the heterogeneity. For example, China had the pandemic largely under control by the second quarter of 2020, which may have led to the faster recovery of capital inflows. For inflows, as major advanced economies adopted accommodative monetary policy stances throughout the course of the pandemic, the risk appetite for global investors was maintained, thereby facilitating capital flow back to the EMs.
In addition, foreign investors have increasingly adopted benchmark-driven investments (BDI), a portfolio allocation method guided by targeted country weights in an index. The use of benchmarks implies a shift from an active management method to a passive one and presents both benefits and risks for EMs. While inclusion in major benchmark indices provides countries with access to a larger and more diverse pool of external financing, growing assets under management of passive and weakly active investment funds boost the role of external drivers, making emerging markets more susceptible to swings in global financial conditions.
As the global public health situation continues to evolve with the Delta variant of COVID-19, uncertainties still abound. Countries should remain vigilant of potential disruptions in their bond markets by continuing to actively monitor the sovereign debt ownership base. The investor composition database can provide important insights to economists and financial analysts on the shifting dynamics of global sovereign debt.