Why the Same Debt Shock Can Become a Market Crisis

The subject is still how government debt moves long-term sovereign rates, but the problem here is the slope of that relationship. Why can a new debt expectation produce an orderly rise in the term premium in one setting and a much larger yield move in another? The answer lies in fiscal space and in the financial system that absorbs government bonds: market depth, debt maturity, intermediary balance sheets and funding conditions can turn a modest repricing into a reinforcing stress episode.

Fiscal space depends on who can hold the debt

The arithmetic of public debt starts with a familiar comparison: the cost of borrowing against the growth of the economy. If interest rates remain below nominal growth for a long period, a government may be able to carry a large debt stock without running large primary surpluses. If borrowing costs rise above growth, stabilising the debt generally requires more fiscal adjustment. That relationship matters, but it is not a complete description of fiscal space.

A government must also find investors willing and able to refinance its bonds. The price at which they do so depends on their balance sheets, funding and risk constraints. If a market is deep and intermediaries have room to warehouse duration, new issuance may be absorbed with a relatively small change in long-term yields. If dealers, funds or other investors are already close to their risk limits, the same quantity of debt may require a much larger rise in the term premium. Fiscal space can narrow even when the long-run path of growth and interest rates has not changed.

This is why a single debt-to-GDP threshold is a poor substitute for analysis. High debt is an important solvency vulnerability, but gross refinancing needs and short maturities create rollover risk. Foreign-currency debt can expose the government to exchange-rate movements; debt linked to inflation or short-term interest rates can make costs adjust quickly when conditions change. A large current-account deficit can signal reliance on external financing that may retreat abruptly. The interest-rate-growth differential helps with debt arithmetic, but the BIS reports that it has limited power to predict sovereign crises on its own and can rise only shortly before a crisis.

The maturity profile creates a tension. Longer maturities reduce the amount of debt that must be refinanced immediately, but they put more duration risk into the portfolios of investors. A rate increase then creates larger mark-to-market losses for holders of long bonds. Shorter maturities pass higher rates into the government’s interest bill more quickly and can make bondholder income respond sooner. At very short maturities, frequent refinancing can expose the government to abrupt changes in risk premia. There is no maturity choice that removes every source of sensitivity; it moves the exposure from one channel to another.

The financial system adds another state variable. In a calm market, abundant liquidity and strong risk-bearing capacity compress the spread investors require to hold government debt. When volatility rises or intermediary capital becomes scarce, that compression can unwind. At the same time, the market becomes less able to absorb additional issuance without a price concession. Borrowing costs therefore rise both because the starting spread is higher and because the debt-to-yield curve becomes steeper.

The change in sovereign-debt ownership makes this mechanism more important. The BIS reports that non-bank financial institutions accounted for 53 percent of sovereign debt holdings in advanced economies in 2025, up from 44 percent in 2021.