Financial stability limits on fiscal space

Fabrizio Zampolli

No 1339, BIS Working Papers from Bank for International Settlements

Abstract: Conventional indicators of fiscal sustainability, such as the interest rate-growth differential that focus on long-term drivers do not always incorporate fluctuating financial conditions and risk. This paper proposes an analytical framework in which sovereign borrowing costs depend on the balance-sheet capacity of financial intermediaries, where financial amplification can generate an endogenously tighter debt limit even in the absence of fiscal fatigue or explicit default risk. Fiscal space becomes state-contingent: identical yield shocks compress fiscal space more strongly when the economy is closer to its debt limit. We examine four financial amplification mechanisms: the bank-sovereign nexus, "original sin redux" , duration matching, and deleveraging in repo markets.

Keywords: fiscal sustainability; fiscal space; debt limit; financial stability; sovereign bond market; non-bank financial institutions (search for similar items in EconPapers)
JEL-codes: E43 E44 E62 G23 H63 (search for similar items in EconPapers)
Date: 2026-03
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