Is Banks’ Home Bias Good or Bad for Public Debt Sustainability?

Motivated by the recent increase in domestic banks' holdings of domestic sovereign debt(i.e., home bias) in the European periphery, this paper analyzes implications of banks'home bias for the sovereign's debt sustainability. The main findings, based on a sample ofadvanced (AM) and emerging market (EM) economies, suggest that home bias generallyreduces the cost of borrowing for AMs and EMs when debt levels are moderate to high. Aworsening of market sentiments appears to dimish the favorable impact of home bias oncost of borrowing particularly for EMs. In addition, for AMs and EMs, higher home biasis associated with higher debt levels, and less responsive fiscal policy. The findingssuggest that home bias indeed matters for debt sustainability: Home bias may providefiscal breathing space, but delays in fiscal consolidation may actually delay problems untildebt reaches dangerously high levels.