Financial stability limits on fiscal space

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.