Fiscal expectations, the sovereign–bank nexus, and bond yields in emerging and developing economies

What drives domestic sovereign bond yields in Emerging Market and Developing Economies (EMDEs)? This paper shows that fiscal policy expectations are central to domestic yields, with effects amplified by the sovereign–bank nexus. A tractable Fiscal Theory of the Price Level framework explains why fiscal shocks affect domestic but not external bond yields. Following Laubach (2009)’s approach, a 1 percentage point increase in expected primary deficits raises 10-year domestic yields by about 36 basis points, rising to 50 basis points in countries with elevated bank exposures to sovereign debt. In contrast, external bond spreads respond mainly to global risk factors. These findings highlight the role of fiscal expectations and domestic financial structure in shaping sovereign borrowing costs in EMDEs.