IMF fears a sharp rise in risk premiums as public finances worsen and inflation remains high

The deterioration of public finances and rising prices are putting pressure on debt markets. The International Monetary Fund (IMF) warned on Tuesday in its Global Financial Stability Report that “resurgent inflation or fiscal concerns could drive a sharp rise in sovereign bond yields, with potentially broad repercussions across financial markets,” at a time when government debt is already at record levels and requires refinancing.

Although financial markets have weathered the geopolitical shocks of the past year, developments in bond markets in some of the world’s major advanced economies are beginning to reflect growing concern over public finances. France is one of the most visible examples. Its sovereign bond yields are hovering near levels not seen in almost two decades, approaching 5%, amid a backdrop of widening budget deficits and the large amount of debt the government will need to issue and refinance in the coming years. In addition, the lack of progress on fiscal consolidation has led investors to demand higher returns to hold French debt.

But France is not an isolated case. After the debt issued during the pandemic and the energy crisis, advanced economies continue to face substantial borrowing needs. Compounding this is refinancing risk, known in market jargon as rollover risk, stemming from the large volume of bonds now reaching maturity and requiring renewal at a time when interest rates are far higher than they were a decade ago. In 2016, borrowing costs in Europe fell to historic lows, with deposit rates even slipping into negative territory.

In recent years, some countries have chosen to issue debt with shorter maturities to limit their initial interest costs. That strategy, adopted by the United States, the United Kingdom and Japan, reduces borrowing costs in the short term but leaves a greater share of debt exposed to prevailing market conditions when it comes time to refinance.

Debt markets are also being shaped by the rapid growth of artificial intelligence and the energy transition, both of which require vast amounts of capital to finance investment. Large technology companies have increased their presence in fixed-income markets and now account for nearly 10% of global investment-grade corporate bond issuance, that is, bonds issued by highly rated companies with a low risk of default.

The IMF stresses that “surging AI-related debt issuances that may compete with sovereign bonds for investor demand has also been cited as an additional source of pressure on bond markets.”

Backing for European debt mutualization

Against a backdrop of strains in sovereign debt markets, the IMF examines mechanisms that could reduce the risk of financial fragmentation. The report highlights the issuance of joint European debt and the mutualization of fiscal risk as a successful example, referring to the instruments created during the pandemic under the Next Generation EU recovery package.

According to the IMF, these measures have helped significantly narrow yield spreads between German government bonds and those of southern European countries, including Greece, Italy, Portugal and Spain. “By introducing common borrowing and transfers to member states, these programs have strengthened perceptions of fiscal risk sharing and helped reduce concerns about debt sustainability and redenomination risk,” the report states.

Spain offers a particularly striking example, not only because the spread between Spanish and German 10-year government bonds has barely moved following the announcement of a snap election, remaining at around 61 basis points, but also because Spanish debt has largely avoided the sell-off affecting sovereign bonds in other countries across the region. That resilience reflects strong economic growth, a robust labor market and a decline in the public debt ratio to below 100% of GDP for the first time since the pandemic.

According to analysts, the broader lesson is that shared debt instruments can serve as a firewall against future crises, at least within the European Union. Common borrowing helps offset the fiscal vulnerabilities of some member states and limits contagion when concerns arise about the solvency of a particular country. That said, it is no substitute for putting public finances on a sounder footing.

Meanwhile, the institution headed by Kristalina Georgieva believes the global banking system could withstand a new economic crisis, although the share of banks whose solvency would come under pressure has increased since 2025. In the IMF’s view, a prolonged period of higher interest rates, combined with elevated energy prices, persistent inflation, and a decline in the value of technology companies, would raise the proportion of vulnerable banks from 18% last year to 22% in 2026.

The impact would not be uniform. Economies that rely on imported energy would be hit hardest, with higher rates of loan delinquencies among both businesses and households. Asia would suffer the largest capital losses, with banks’ capital adequacy ratios falling by nine percentage points. Europe would follow, where higher energy costs, coupled with elevated interest rates, would weaken banks’ loan portfolios.

In the United States and Canada, losses would stem primarily from declines in the value of bonds held on bank balance sheets. Under the most adverse scenario, the institutions facing the greatest strain would account for 7% of global banking assets and would require $68 billion in additional capital to restore required capital levels.

Even so, IMF experts believe the sector’s capital and liquidity buffers would enable banks to absorb part of those losses without triggering a systemic crisis.

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