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posted on 13 September 2017

Government Debt In Domestic Hands During A Crisis

from the Philadelphia Fed

-- this post authored by Burcu Eyigungor

When banks load up on their government’s bonds, lending to firms and households can get crowded out. But when the sovereign debt market is in turmoil, such concentrations may play a surprising role.

After adopting the euro in 2002, Greece, Ireland, Spain, and Portugal found that banks and investors in other euro area countries were more eager to buy their government bonds. This rise in foreign demand for the sovereign debt of these smaller, less economically robust countries on the periphery of Europe’s common currency zone came as no surprise and was in fact intended. A major reason for adopting a single currency was to promote linkages among the national economies and banking systems of the member countries, thereby boosting trade and demand overall.1 Indeed, the increased desire to invest in peripheral countries’ bonds was a sign that markets had begun to view their risk at least partly as a function of the financial strength of the entire euro area (Figure 1), dominated by the major economies of Germany and France.

The rise in foreign demand for the bonds of the peripheral countries kept yields down even as inflation in these economies rose. And their governments, firms, and households took advantage of the resulting decline in borrowing costs, in some cases steeply increasing their national debt as a share of their national gross domestic product and raising their underlying risk of defaulting on their bonds.

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