In highly indebted economies, an important aspect of monetary policy is the dynamics behind domestic banks’ demand for government debt. Due to greater financing needs, government securities comprise a high – and rising – share of bank assets in multiple low- and middle-income economies, with a notable post-pandemic strengthening in the sovereign-banking system nexus in Africa and the Middle East. When policy rates rise, for example, the impact of higher interest rates reverberates beyond household mortgages and business loans, raising funding costs and reducing the asset values that underpin liquidity access.
Fragility is visible in Egypt, where domestic (commercial and state-owned) banks hold government debt equivalent to 50% of their total assets – among the highest values within emerging economies – potentially exposing the banking system to debt risks. Egypt’s interest payments have reached 5070% of government revenue, highlighting the continued need for effective debt management under its IMF programs. In Kenya, interest costs account for over 30% of fiscal revenue. Nigeria’s sovereign–bank nexus, linked in part to its ‘Ways and Means’ financing, also indicates elevated domestic bank holdings of government securities, sustaining fiscal–monetary feedback risks.
India offers an example of how coordinated sovereign debt and central bank operations can foster financial stability. The Reserve Bank of India’s balance sheet has expanded consistently through liquidity and bond operations, its foreign exchange reserves are approximately US$650bn and 80% of government debt is held domestically. At 4.4% of GDP, India’s fiscal deficit has been met with inflation largely in control, and inflation volatility in decline (Figure 1) reflecting aligned liquidity operations, bond market support, and foreign exchange management.
Bank Indonesia (BI) provides another example of successful coordination. During the pandemic, BI shared the burden of government financing, of bond purchases, as public debt rose from 30% to 40% of GDP between 2019 and 2022. The credibility of BI’s intervention – notably its ability to withdraw support while containing inflation expectations – was key in supporting its foreign exchange buffers. More recently, as inflation volatility has spiked, BI’s proactive rate hikes and currency intervention have been deployed.
Ghana’s 2022-2023 domestic debt restructuring affected roughly one-third of its outstanding local-currency government bonds held by domestic financial institutions. Inflation peaked at 54% annually in December 2022, in part a reflection of the food and fuel price shock following Russia’s February 2022 invasion of Ukraine. At the time, as bonds stopped being viewed as safe collateral, domestic banks scaled back their holdings, significantly exacerbating domestic financial instability.
The Central Bank of Nigeria (CBN) has attempted to mitigate a different form of instability. It began a tightening cycle in May 2022, following the US Federal Open Market Committee’s move in March 2022. The CBN also provided large-scale support through overdrafts, targeted lending and foreign exchange interventions. A feature of Nigeria’s domestic financial system has been persistent gaps between the official(investors and exporters’ window) and parallel market exchange rates, with premia often ranging between 30% to 50% during periods of FX scarcity.
Countries with stable fiscal positions, typically contained annual inflation rates that are at, or below, respective country targets, debt ratios that are broadly below 60% of GDP thresholds, and strong foreign exchange reserve buffers will see tightening transmitted in a conventional way, and comparative resilience in their domestic financial systems. Countries with inflation-fighting, or fiscal credibility in question, could experience global monetary tightening as a more acute funding and liquidity stress event and a broader macroeconomic shock.