Procyclical fragility: Sovereign debt, the global financial cycle, and banking-sector stress in emerging markets

This study examines the sovereign-banking nexus in emerging markets through the channel where it is identifiable at the country level: banks’ balance-sheet soundness in response to sovereign external debt accumulation. Using a panel of 55 emerging-market economies over 2000–2024 and a diagnostic-first estimation strategy, we estimate a System GMM specification in which sovereign debt is treated as endogenous, with overidentification and serial-correlation diagnostics reported throughout the analysis. Four findings emerge. First, external debt raises non-performing loan (NPL) ratios, and the effect is robust across a stability ladder spanning institutional quality, exchange-rate conditions, and the macro-financial environment; the System GMM specification restores the instrument validity that difference-GMM estimation of this relationship fails to achieve. Second, the relationship is linear across the observed debt range: a Hansen (1999) panel threshold test detects no significant threshold, implying that fragility accumulates continuously with no “safe” level of debt. Third, the nexus is a post-crisis phenomenon: formal break tests (Chow, supF, Bai–Perron) identify a structural break at the onset of the global financial crisis, and rolling estimates show the relationship intensifying over the post-crisis decade. Fourth, the marginal effect of debt is conditioned on the global financial cycle, strongest in calm markets and attenuating as global volatility rises. Capital adequacy erosion, by contrast, is driven primarily by inflation. These findings imply that supervisory monitoring of bank balance-sheet trajectories is a more dependable early-warning tool for sovereign-debt-driven banking risk than market-based spread signals, which are available only for the most financially developed emerging markets.