Serkan Arslanalp and Takahiro Tsuda

Recent events have shown that sovereigns, just like banks, can be subject to runs. Hence, it pays to know who holds their liabilities. This article explains the construction of a dataset on investor holdings of sovereign debt to track investor demand for advanced economy sovereign debt. It also discusses new risk indicators to capture both the vulnerability to and likelihood of potential investor shifts and their domestic financial stability implications.

There has been a lot of discussion about how the supply of sovereign debt changed after the global financial crisis. Compilation of the comprehensive historical public debt database by IMF economists reflects such renewed interest in public debt (Abbas and others, 2010). Yet, less attention has been paid to how the demand side has been changing, although shifts in the investor base for sovereign debt can have signifcant effects on government borrowing costs, as recently witnessed in a number of euro area countries.

The analysis of demand-side dynamics for sovereign debt is particularly challenging due to the lack of internationally comparable investor base estimates. For instance, (i) investor base data from national debt management offices usually cover only a subset of government debt (e.g., central government); (ii) national flow of funds data are not always internationally comparable; and (iii) data from private sector vendors (e.g., survey or custodial data) usually cover only a small share of the investor base.

Recent IMF staff research (Arslanalp and Tsuda, 2012) takes a step toward filling this data gap by compiling a comprehensive investor base dataset for 24 major advanced economies, covering 98 percent of the advanced economy sovereign debt universe.

The composition of sovereign investor base is important because shifts in the sovereign investor base can affect (i) governments’ borrowing costs; (ii) governments’ refinancing risks; and (iii) domestic financial stability.

The previous literature tended to focus on implications for governments’ borrowing costs (Friedman and Roley, 1980). Several studies show that an increase in the share of foreign investors or domestic institutional investors in the investor base is associated with lower sovereign bond yields (Andritzky, 2012; Warnock and Warnock, 2009).

The implications of the post-crisis changes in sovereign investor base for governments’ refinancing risks and domestic financial stability is the focus of this article. On the one hand, a rising share of foreign private investors in the investor base can heighten governments’ refinancing risk because they could be a less stable source of demand. On the other hand, a high share of domestic banks in the investor base may jeopardize domestic financial stability through a strong two-way interdependence between the sovereign and domestic bank balance sheets (BIS, 2011; Merler and Pisani-Ferry, 2012).

The investor base dataset¹ has the following characteristics: First, a common definition of sovereign debt is used (general government gross debt on a consolidated basis). Second, a common estimation methodology is used to ensure crosscountry comparability based on harmonized international data sources, such as the Bank for International Settlements (BIS), IMF, and World Bank. Third, all data are compiled either in face value or adjusted for valuation changes, where appropriate. Fourth, this dataset tracks transactions and holdings of six different investor classes—domestic central banks, domestic banks, domestic nonbanks, foreign official sector, foreign banks, and foreign nonbanks, in contrast to national data sources that usually classify foreign investors under one category (“rest of the world”). While this article covers advanced economies, the methodology is general enough to cover emerging market economies too.

The dataset can be used to analyze demand-side dynamics through a number of different prisms:

• For example, Figure 1 shows the estimated investment flows of foreign investors since 2008. This is a tool that policymakers can use to track foreign investor flow across all major advanced economies with a quarter lag. All investor flows are de-trended and scaled by the inverse of country-specific standard deviations to make them cross-comparable (i.e., based on z-scores). The mean and the standard deviation for the z-scores are calculated using an expanding window starting from 2004Q1, in line with the sudden stop identification methodology of Calvo and others (2004). The figure shows that, during the global financial crisis (2008–09), foreign investors increased their holdings of most advanced economy sovereign debt, reflecting its perceived risk-free status during that time. In the later period, however, they started to differentiate among different sovereigns, amid the ongoing euro area sovereign debt turmoil. Most recently, the European Central Bank’s announcement on outright monetary transactions (OMT) in August 2012 stabilized foreign investor outflows from euro area periphery government debt markets.

• Another use of this dataset includes analysis of portfolio shifts by different types of foreign investors. In particular, foreign central banks behaved quite differently from foreign private investors: post-crisis, they have significantly diversified their portfolios toward “alternative safe haven” currencies. For instance, foreign central bank holdings of Australian sovereign debt have quadrupled over the last two years, according to the dataset.

• Sovereign exposures of domestic banks were also on the rise after the global financial crisis across most advanced economies, both in nominal terms and as a percent of banking sector assets (Figure 2). This may reflect cyclical factors, such as weak growth conditions, as well as structural factors, such as banks’ need to deleverage, preparations for implementing the new financial regulations including Basel III, and possibly home bias.

Advanced Economies: Foreign Net Purchases and Sales of Government Debt, 2008Q1-2012Q3

Citation: IMF Research Bulletin 2013, 001; 10.5089/9781484395660.026.A002

Source: Arslanalp and Tsuda (2012).Note: The z-scores measure the relative size of net sales (purple) or purchases (green) of government debt by foreign investors, compared to historical norms.They are color coded as follows: purple (less than -1); yellow (between -1 and -0.5); light yellow (between -0.5 and 0.5); light green (between 0.5 and 1); and green (greater than 1).

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Advanced Economies: Foreign Net Purchases and Sales of Government Debt, 2008Q1-2012Q3

Citation: IMF Research Bulletin 2013, 001; 10.5089/9781484395660.026.A002

Source: Arslanalp and Tsuda (2012).Note: The z-scores measure the relative size of net sales (purple) or purchases (green) of government debt by foreign investors, compared to historical norms.They are color coded as follows: purple (less than -1); yellow (between -1 and -0.5); light yellow (between -0.5 and 0.5); light green (between 0.5 and 1); and green (greater than 1).

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Advanced Economies: Foreign Net Purchases and Sales of Government Debt, 2008Q1-2012Q3

Citation: IMF Research Bulletin 2013, 001; 10.5089/9781484395660.026.A002

Source: Arslanalp and Tsuda (2012).Note: The z-scores measure the relative size of net sales (purple) or purchases (green) of government debt by foreign investors, compared to historical norms.They are color coded as follows: purple (less than -1); yellow (between -1 and -0.5); light yellow (between -0.5 and 0.5); light green (between 0.5 and 1); and green (greater than 1).

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Bank Holdings of Own Government Debt in Advanced Economies, 2004Q1-2012Q3

Citation: IMF Research Bulletin 2013, 001; 10.5089/9781484395660.026.A002

Source: Arslanalp and Tsuda (2012).

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Bank Holdings of Own Government Debt in Advanced Economies, 2004Q1-2012Q3

Citation: IMF Research Bulletin 2013, 001; 10.5089/9781484395660.026.A002

Source: Arslanalp and Tsuda (2012).

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Bank Holdings of Own Government Debt in Advanced Economies, 2004Q1-2012Q3

Citation: IMF Research Bulletin 2013, 001; 10.5089/9781484395660.026.A002

Source: Arslanalp and Tsuda (2012).

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Taken together, advanced countries could face more uncertain funding conditions in the future given their higher reliance on foreign investors and growing exposure of their banks to own government debt. In light of these potential risks, the paper proposes a framework—sovereign funding shock scenarios (FSS)—to assess sovereigns’ vulnerability to sudden investor outflows. It envisages a funding shock that is triggered by foreign private investor outflow and then examines whether domestic banks can step in to fill the gap. A higher level of sovereign debt that would be held by domestic banks suggests growing interdependence between banks and the sovereign, which could jeopardize domestic financial stability. As the standard debt sustainability analyses (DSA) does not capture vulnerability to liquidity shocks or sudden stop, the FSS can complement the DSA in that regard.

While FSS aim to capture the vulnerability stemming from investor outflow, the proposed Investor Risk Index (IRI) attempts to capture the likelihood of outflow by different types of investors. The index runs from zero to one hundred, based on the composition of the investor base and the risk scores assigned to different investors given the way they tend to change their holdings. By this metric, countries with a high share of domestic investors, as well as foreign central banks, in their investor base receive lower scores. In contrast, high scores are assigned to countries whose investor base has a high share of foreign private investors. Distinguishing between foreign central banks and foreign private investors is useful, particularly for countries where the foreign official sector accounts for a large share of foreign investors (e.g., Australia).

The resulting risk indicators need to be interpreted with caution. For instance, the FSS is a stress-test approach, thus silent on the probability of shocks. Setting parameters and scenarios requires economic intuition and judgment. Also, the IRI alone does not predict a future crisis as such. Rather, the IRI could be combined with other risk indicators, such as current or projected debt-to-GDP ratios, to provide a more comprehensive measure of sovereign risk. For example, Finland has a high IRI, but with its low debt-to-GDP ratio the country is not necessarily prone to investor outflow. At the same time, although Japan’s IRI is low owing to its domestically concentrated investor base, its high debt-to-GDP ratio remains worrisome. Our related blog post highlights this point (Arslanalp and Tsuda, 2013). Moreover, current account imbalances (more specifically, international investment position) also can be used along with the IRI to better gauge risks of investor flows from the economy. Finally, interpretation of the IRI can vary depending on the exchange rate regime, as a floating exchange rate probably provides a safety value against foreign outflows.

Despite these limitations, these risk indicators can help understand demand dynamics of sovereign debt, suggesting lessons for policymakers. First, public debt managers should continue to pay attention to investor relations and monitor government refinancing risk closely through rigorous scenario analysis. Second, financial sector supervisors should place more emphasis on macrofinancial risks emanating from bank holdings of sovereign debt. Continuous monitoring of sovereign-bank interlinkages is warranted. Third, standard DSA should be complemented with investor base risk indicators to capture sovereign risk in a more comprehensive fashion. Finally, further efforts to reduce data gaps on investor holdings of sovereign debt could be of significant benefit to policymakers, in line with the G-20 Data Gaps Initiative.