European governments' fiscal behaviour and public debt holders : what is the financial connection?

Concerns about fiscal sustainability and worsening balance sheet conditions of major banks triggered a doom loop between banks and sovereigns during the 2010-2013 sovereign debt crisis. Despite closer financial integration and additional institutional safeguards, the home bias, i.e. domestic bank holdings of domestic sovereign debt, is still high in most EU countries. We examine the effects of home bias on fiscal sustainability. In this paper, fiscal sustainability is understood in a broad sense of a government's ability to manage its finances in a way that ensures the long-term viability of its economic and social programmes, without compromising the stability of its financial system. We first extend two IMF databases on sovereign debt holdings to all EU Member States. We then apply panel smooth transition regression models on a fiscal rule. We find that a high home bias does not reduce the reaction of governments to public debt, but only if the financial system is sufficiently developed. A developed banking system allows sovereigns to raise more public debt at acceptable conditions to support economic stabilisation. An increased presence of foreign banks has a benign effect on sustainability by reducing governments' debt bias, but state-owned banks reduce it. We further test fiscal responses to public debt shocks with an interacted panel Vector Auto Regression model. Even though governments respond to public debt under a high home bias, they react only slowly and delay fiscal consolidations. Developing financial markets further through the completion of the Banking and Capital Markets Unions in the EU could help countries in the trade-off between economic stabilisation and debt sustainability, while bringing in more foreign banks might enforce stronger fiscal discipline.