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IMF raises red flag on emerging economies “doom loop”

by Business News Report

International Monetary Fund, has raised a red flag on  what it called potential “doom loop” emerging economies in which Nigeria is classified by the multilateral institution. It said this in a report, titled “Emerging-Market Banks’ Government Debt Holdings Pose Financial Stability Risks”. In Nigeria bank credit to the public sector surged to N14.9 trillion as of February 2022, an uptick from the N14.2 recorded in January 2022. The unprecedented levels of government debt, raising the risk that public-sector financial pressures would jeopardise financial stability in most emerging markets and developing economies. IMF in the report said that there is a reason to worry about this nexus between banks and governments. “Large holdings of sovereign debt expose banks to losses if government finances come under pressure and the market value of government debt declines,” it stated.

The Multilateral Institution said that a crisis with the credit to the government could force banks, especially those with less capital “to curtail lending to companies and households, weighing on economic activity.“ It added that “The sovereign-bank nexus could lead to a self-reinforcing adverse feedback loop that ultimately could force the government into default. There is a name for that, too—the “doom loop.” It happened in Russia in 1998 and in Argentina in 2001-02.” The IMF also noted that rising returns in advanced countries as central banks start to normalise monetary policy might make emerging-market debt less attractive and put upward pressure on borrowing prices. A doom loop is a negative spiral that can occur when banks hold sovereign bonds and governments with weak public finances bail out such banks.

Governments are exposed to bank risk, as well as banks are exposed to sovereign risk by holding government bonds in their portfolios. Other names for the doom loop include the “diabolic loop” and “vicious circle”. The IMF stated that “A sharp tightening of global financial conditions—resulting in higher interest rates and weaker currencies on the back of monetary policy normalisation in advanced economies and intensifying geopolitical tensions caused by the war in Ukraine—could undermine investor confidence in the ability of emerging-market governments to repay debts.“ Domestic shocks, such as an unanticipated economic slowdown, might also have the same effect, according to the World Bank. A cursory look at the Nigerian situation showed that bank credit to the government increased by N1.33 trillion in 2021, rising to N13.73 trillion as of December 2021 from N12.4 trillion recorded the previous year. The Debt Management Office said that Nigeria became the first African country to raise $1.25 billion through the issuance of Eurobonds in the International Capital Markert. It also said that Nigeria’s total public debt has risen to N39.55 trillion as of December 2021. This represents an N1.55 trillion or 4.1% increase in 3 months when compared to the N38 trillion total public debt that was recorded as of September 2021.

Emerging-market governments rely significantly on their banks for lending, while banks rely heavily on government bonds as an investment that they can use as collateral to secure central bank funding. According to the IMF’s April 2022 Global Financial Stability report the average ratio of public debt to the gross domestic product—a key measure of a country’s fiscal health—rose to a record 67% in emerging market countries last year. Emerging-market banks have given the majority of the lending, pushing government debt holdings as a proportion of assets to a new high of 17%  in 2021.

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