The Sovereign-Bank Nexus in Emerging Markets and Developing Economies

As public debt in emerging markets (EMs) and low-income countries (LICs) has surged since the COVID-19 pandemic, so has the exposure of domestic banks to their sovereigns—raising concerns of destabilizing feedback loops if fiscal conditions deteriorate. This paper provides a comprehensive analysis of this sovereign-bank nexus using a new granular dataset covering over 120 EMs and LICs, combined with IMF Financial Soundness Indicators. We document a marked post-pandemic strengthening of the nexus, particularly in Sub-Saharan Africa and the Middle East and Central Asia, and show that public debt levels, deposit rates, and nonperforming loans are its most robust correlates. While we find no broad evidence of financial repression, higher sovereign refinancing needs significantly increase banks' government debt holdings in countries with substantial state-owned bank presence. Sensitivity analysis illustrates that the consequences of a strong nexus can be severe: even a moderate domestic debt restructuring could render several banking systems undercapitalized, underscoring that high reported capital ratios in strong-nexus countries may provide a false sense of security.