On Sovereign Risk and the Financial System in South Africa

Abstract

Local-currency government bonds have emerged as the predominant source of financing for emerging-market sovereigns. While the development of these markets has enhanced the resilience of emerging markets to external shocks, it has also introduced new vulnerabilities. Among these, sovereign default risk on local currency-denominated debt is becoming increasingly relevant as the indebtedness of emerging-market governments such as South Africa’s increases, especially after the Covid-related fiscal shocks of 2020. As such, there has been growing interest in the impact of government debt and sovereign risk on the financial system. However, much of the work analysing sovereign default risk in emerging markets still relies on measures that are based on their foreign-currency denominated debt, despite the dominance of local-currency bond issuance. In this thesis, I explore local currency sovereign risk and its influence on the financial system in South Africa. Using a local-currency measure of sovereign risk, I explore three specific questions. First, I examine the role of sovereign and exchange rate risk as drivers of changes in nominal government bond yields in South Africa. Second, I consider the impact of government bond holdings and sovereign risk on emerging- market bank valuations and performance. Lastly, I analyse interactions between fiscal and monetary policy, first in a panel of emerging markets and then in South Africa specifically. The findings of my thesis have implications for emerging markets in general. I find that increases in sovereign risk have adverse impacts on government borrowing costs, the banking system, bondholders, and the monetary authority. Furthermore, the spillovers that the financial system experiences from sovereign risk are largely a function of the level of exposure to sovereign debt.