The role of households in financing government debt in the euro area

Prepared by Jeanne Pavot and Vilém Valenta

Published as part of the ECB Economic Bulletin, Issue 3/2021.

1 Introduction

The coronavirus (COVID-19) pandemic has reinvigorated interest in how governments finance their spending to an extent not seen since the global financial and euro area sovereign debt crises of 2008-12. Economic crises of such depth require governments to take decisions on how far the crisis-related costs should be financed by spending cuts elsewhere in the budget, by revenue increases and/or by incurring additional debt. At the same time increases in government debt raise questions as to the optimal financing strategy in terms of instruments and maturities, but also the investor base.

The composition of government debt has important financial and economic policy implications. Recent literature has pointed to the fact that the structure of government debt by holder can give insights into issues such as the diversification of risks in government debt issuance. It is also relevant to the strength of the sovereign-bank nexus and overall financial stability, the probability and effectiveness of sovereign debt restructuring, income inequality and the size of fiscal multipliers (see Section 2).

Against this background, the article first provides an overview of the evolution of the structure of public debt by holder in euro area countries since 1995. Literature on government debt composition has traditionally focused on distinguishing shares of domestic and foreign-held debt, with less emphasis on analysing a more detailed disaggregation by domestic holders. In this article we analyse more granular data on domestically held government debt to assess the role of non-bank actors in financial intermediation as well as the effects of the Eurosystem’s purchases of government securities on the composition of government debt by institutional sector (Section 3).

The article then explores in more detail the structure of domestically held government debt with a special focus on the household sector. With increases in the level of government debt and in the share of domestically held debt, an analysis of the public debt composition in terms of institutional sector becomes increasingly relevant, including the role of households as savings providers. For an assessment to be meaningful, the size not only of direct holdings by households should be considered, but also the size of their indirect holdings through investment funds, insurance corporations and pension funds. The aim of the article is not to provide a full picture or normative assessment of the ultimate owners of government debt but rather a factual analysis of the size and evolution of households’ holdings of government debt in the euro area, also in comparison with selected advanced economies (Section 4). For euro area countries this relies on the breakdown in the financial sector accounts ‒ known as the “who-to-whom” data ‒ published by the ECB and euro area countries. Similar datasets are available also for other EU Member States and the other advanced economies.

2 Main implications of the structure of government debt holdings

There is a large body of literature examining government debt composition by holder, but the analysis of holdings of households is more limited. Several studies analyse the holdings of public debt in the euro area by the non-financial sector and by non-residents, but they do not include households or retail government debt programmes.^[1] A greater number of studies, using both macro- and microdata, are available for the United States, especially with regard to municipal debt where households traditionally have a key role.^[2]

The composition of government debt holdings, including by households, is relevant to economic analysis in several areas covered in the literature.

• Public debt management. Broadening the investor base across domestic investors (residents of the country whose government has issued the debt) and foreign investors as well as across interest-sensitive and insensitive investors is a key tool in diversifying the refinancing risk and reducing borrowing costs.
• Financial stability. Feedback loops originating from domestic holdings and potential cross-border spillovers from foreign government debt holdings are important parameters for financial stability. An increased funding diversification for governments, less dependent on domestic banks and with a larger share of bonds sold to other investors can reduce such risks.
• Safe assets. Higher risk in times of economic crisis increases the demand for safe assets. Government bonds represent the main source of high-quality assets in the euro area.^[3] Households are risk-averse investors and hold relatively little government debt directly, but indirect holdings via pension and investment funds and insurance corporations are much more common. Bank deposits are the main safe asset for households. In turn, the safety of bank deposits is underpinned, apart from deposit insurance, by the ability of banks to pledge collateral in the form of government bonds to the central bank. Sovereign debt thus plays a vital role in giving households financial safety.
• Sovereign debt sustainability. On the one hand, domestic debt holdings represent a more stable investor base. They can also make sovereign default less likely because they increase the incentives for debt repayment as the cost of a potential non-repayment is borne by residents.^[4] On the other hand, large domestic holdings of government debt can have a destabilising effect because they generate feedback loops between the public and private sectors during crises.^[5]
• Income inequality. The impact of public debt on distributional aspects and wealth inequalities is explored in the literature. Although many papers analyse only the redistributive dimension across generations, some papers also cover within-cohort wealth redistribution originating from bond holdings, including government bonds.^[6] As households’ holdings of government debt are concentrated among the wealthiest households and government bonds normally offer higher yields than bank deposits, the government debt holding structure can lead to regressive distributional effects.
• Fiscal multipliers. Evidence suggests that a higher share of domestically held government debt may reduce the size of fiscal multipliers owing to stronger crowding-out of private investment.^[7]

3 Structure of government debt holdings in the euro area

Capturing long-term trends in the structure of government debt holdings in the euro area is not straightforward because of a lack of data. While it is possible to build data on the level of the government debt over a very long period, reporting on government creditors has long been more fragmented and less reliable.^[8] The global financial crisis (GFC) triggered many initiatives to cover the data gap and more granular data are now available allowing to better capture the structure of government debt holdings.^[9] However, these data cover only a relatively short period of time. In annual government finance statistics, a breakdown of the holders of government debt has been available for most euro area countries since 1995.^[10] The category of resident or domestic creditors refers to holders that are resident in the country whose government has issued the debt. Non-residents includes both residents of other euro area countries and residents of countries outside the euro area.^[11] The resident creditors include the financial sector and the non-financial sector (Table 1). The financial sector creditors are the central bank, other monetary financial institutions (other MFIs or banks), and the other financial corporations (OFCs). The latter mainly include investment funds (IFs) and insurance corporations and pension funds (ICPFs).^[12] Lastly, the non-financial sector (resident creditors) aggregates non-financial corporations (NFCs) and households.^[13] The composition of government debt is determined by a number of demand and supply factors, such as the liquidity conditions in the sovereign markets, the marketability of the debt instruments and the institutional framework for debt and inflation management. Table 1 shows significant heterogeneities across the euro area countries. This section focuses on the main drivers behind the shifts in the composition of government debt over 1995-2020.

The share of euro area government debt held by residents declined substantially before the GFC and increased again afterwards. With the exception of a few countries in which the government debt-to-GDP ratio is very low in comparison with the euro area average (like Estonia, Lithuania, Luxembourg or Malta), there was an overall increase in the share of non-resident holdings before the GFC (Chart 1). There is evidence of growing financial integration within the euro area after the introduction of the euro.^[14] The GFC had a major impact on cross-border portfolio investments, which was compounded by the euro area sovereign debt crisis in 2010-12. Global investors shifted their portfolio investment away from euro area countries that were perceived to be under stress.^[15] In Spain and Italy, the share of government debt held by non-residents dropped between 2010 and 2015. Similar trends prevailed in Greece, Ireland and Portugal, and later in Cyprus, after excluding the loans granted by non-resident creditors under the EU/IMF financial assistance programmes. In other countries, like Germany and France, the share of non-resident holdings stabilised. It stood at around 50% in 2015 at euro area level. The overall reduction in the share of non-resident holdings of government debt has mostly been driven by the Eurosystem’s sovereign bond purchases under the public sector purchase programme (PSPP) since 2015 and under the pandemic emergency purchase programme (PEPP) since 2020.^[16] By reducing yields on securities, these programmes also prompted investors to shift their investments towards assets with higher expected returns. Foreign investors have rebalanced their portfolios towards more attractive investments.^[17]

The increase in domestic holdings of government debt was mainly driven by non-monetary financial institutions until the euro area sovereign debt crisis and thereafter by monetary financial institutions including central banks. Chart 1 shows the available breakdown of domestic holders. Before the GFC, resident banks and other financial corporations hold the most government debt. Central banks and the other domestic holders are less significant creditors, except for in Ireland, Spain, Italy, Malta and Portugal where households and NFCs’ holdings are more prominent, although their weight is declining. The chart shows that before the GFC, the relative share in government debt of OFCs grew in most countries while the banks’ share declined. Structural factors, including population ageing and institutional factors such as pension reforms encouraging private retirement saving schemes contributed to the increased holdings by OFCs, in particular by ICPFs.^[18] During the euro area sovereign debt crisis, the share of government debt held by banks increased in countries that were subject to financial market pressure thus reinforcing the sovereign-bank nexus. Since then, larger capital buffers have strengthened the euro area banks by raising their loss-absorption capacity, and a revised regulatory framework has reduced risks from the sovereign-bank nexus.^[19] Finally, the share of government debt held by central banks has increased since 2015 as a result of the Eurosystem purchases under the PSPP and the PEPP to stand at 20.8% at the euro area level at the end of 2020. At the country level, the data show only the holdings of the national central banks, but the total Eurosystem holdings of domestic government debt cannot be identified from the data because the ECB is classified as a non-resident creditor. Besides, the other euro area central banks also have cross-border holdings of sovereign bonds. Although declining, the share of government bonds held by private, price-sensitive investors, also called “free float”, remains substantial in the euro area.

4 Holdings of government debt by households

More granular data enable an assessment of the role of households in financing the government debt. The annual government finance statistics used in the previous section do not permit such an analysis. The direct government debt holdings of households cannot be distinguished as households and non-financial corporations are grouped together. Nor is the indirect role of households in financing government debt easily observable, as this requires “looking through” financial intermediaries. The financial sector accounts, however, provide a comprehensive framework for the analysis of the role of households in financing government debt. The breakdown in these accounts ‒ “who-to-whom” data ‒ present the financial positions between sectors and therefore provide a more comprehensive view on how government is financed.^[25] Figure 1 illustrates the network of euro area inter-sector claims in the form of deposits, debt securities, investment fund shares and insurance and pension products. It only includes instruments that are relevant for assessing households’ contribution to financing government debt. It does not fully depict how government debt is financed, however, as loans are not included. Moreover, not all financial assets of households are shown, as their holdings in shares and other equities are excluded. ^[26] Nevertheless, it provides an overview of the complexity of the financing relationships in the euro area.

Households contribute both directly and indirectly to the financing of government debt. The households’ direct holdings of government debt correspond to their deposits vis-à-vis the government (see Box 1) plus their holdings of debt securities issued by government entities. Households do not provide loans to governments. However, there is no unique definition of an indirect holding. According to a narrow definition of indirect holding, only indirect holdings via IFs are considered, as individuals select the IF based on the fund’s characteristics and, in particular, the type of assets the fund invests in. In a very broad definition of indirect holding, all financial intermediaries can be considered. For the purposes of this article, we opt for an in-between scope of indirect holdings. ICPFs, as long-term investors, acquire long-term maturity assets, especially sovereign bonds, to match the maturity profile of their liabilities. Their assets can be considered to be held indirectly by households. Conversely, MFI investments in government debt are not considered to be indirect assets of households, as banks do not use the portfolio of assets as collateral to meet their obligations vis-à-vis depositors in fulfilling their transformation function. While households play a significant role in financing government debt through placing deposits in MFIs, which in turn invest in government bonds, this channel is distinguished from indirect holdings of households via resident IFs and ICPFs. This distinction is useful to assess the relative importance of the bank and non-bank financial intermediation.

The indirect holdings still exclude several important channels through which households may contribute to financing government debt. In Figure 1, the channels analysed are highlighted in yellow. Only the direct holdings of resident IFs and ICPFs are taken into account for households’ indirect holdings. For example, there are sizeable financial interlinkages within the resident OFCs (e.g. ICPFs investing in investment funds, with the latter investing in debt securities), which are not considered here as indirect holdings.^[28] Moreover, part of the funds invested by households in non-resident funds are re-invested in government debt but are not included here as households’ indirect holdings.^[29] To enrich the comparison exercise, other advanced economies ‒ the United States, Canada and the United Kingdom ‒ are included.^[30] Quarterly data are available since 1951 (for the United States) and since 2013 (for the euro area countries) until the third quarter of 2020 for all countries. As the outstanding amounts are recorded at market value in financial accounts whereas government debt is reported at face value, the shares of direct and indirect holdings are computed using government debt at market value as a denominator.^[31]

Households’ direct holdings of government debt are relatively low in most euro area countries and have been declining since the introduction of the euro. Table 2 shows for all countries the share of households’ direct holdings of government debt in the form of deposits and debt securities. As highlighted in Box 1, direct holdings in the form of deposits are very specific to several countries in the euro area (mainly Ireland, Italy, Malta and Portugal), but have also been sizeable in the United States, Canada and the United Kingdom. Chart 2 shows an overall declining trend in these forms of savings instruments.^[32] This decline might have resulted from the choice of governments to reduce the scope of relatively costly retail debt programmes. These programmes sometimes offer tax exemptions or interest premia, which makes them more costly compared with market funding. The decline can also originate from a reduction in demand in an environment of low interest rates or a shift to private pension systems. Competition from close substitutes issued by banks might also have contributed to the decline. The direct holdings in the form of securities issued by government also show a strong heterogeneity across countries, being very high in Malta and in the United States and relatively high in Italy. As in the case of deposits, the issuance of special retail bonds contributes to higher direct holdings of households in the form of securities.^[33] In total, households held directly around 2% of government debt in the euro area in the third quarter of 2020, but this figure was close to 20% in Malta, close to 10% in Ireland and Portugal, and around 7% in Italy. The share of government debt held directly by households was close to 15% in the United States and close to 8% in the United Kingdom.

Households’ indirect holdings are lower where banks have a larger share in financial intermediation and higher where financial interlinkages between the other financial corporations are less prevalent. Households held indirectly around 14% of government debt in the euro area in the third quarter of 2020, mirroring the large government securities holdings of IFs and ICPFs (Box 2). The level of indirect holdings depends on the relative importance of IF shares and ICPF products in the households’ total financial assets. In this regard, the relative share of the bank deposits is larger and partly contributes to lower indirect holdings in the euro area than in economies like the United States where the OFCs play a greater role in managing households’ savings. Within the euro area countries, this factor explains lower indirect holdings in Germany, Spain, Cyprus, Malta, Austria, Portugal and Slovakia and the higher level of indirect holdings in the Netherlands where pension funds are particularly developed (Chart 3). The level of indirect holdings is also influenced by the investment strategy of IFs and ICPFs, namely the extent to which they invest directly in assets issued by the non-financial sector to cover their financing needs (such as governments or non-financial corporations), or the extent to which they invest in IFs which ultimately invest in claims issued by the non-financial sector. Chart 4 shows that in the euro area, the intensity of financial interlinkages between OFCs varies across countries and contributes to lower indirect holdings in Germany, the Netherlands, Austria and in Finland as only the direct government debt holdings of IFs and ICPFs is considered.

The total holdings by households of government debt are sizeable and concentrated among the wealthiest households. Households held both directly and indirectly around 16% of government debt in the euro area in the third quarter of 2020, but the level was close to 20% in Malta and Italy, close to 15% in Portugal, and 12% in France (Table 2). In the United States households hold around one-third of the government debt, and in Canada and the United Kingdom the share is close to one quarter. For euro area countries, the Household Finance and Consumption Survey^[34] (HFCS) shows that within each country holdings of government debt instruments are tilted towards the top of the income distribution^[35] (see Chart 5).^[36] The households from among the top 20% of income have a higher propensity to own bonds issued by government. The overall propensity to hold this kind of asset is very low in most of the euro area countries, but there is cross-country heterogeneity as the propensity to hold bonds issued by government is relatively high in Ireland, Italy and Malta. Moreover, households from among the top 20% of income have a higher propensity to have at least one pension plan or life insurance policy. This indicates that such indirect holdings are also biased towards the wealthiest households. The financial literacy, financial sophistication, and the use of professional financial advice play an important role in both the composition of households’ wealth and return on households’ investments and are likely to be an important driver of this bias.^[37]

5 Conclusion

Over the last two decades, the structure of government debt by holder has evolved, driven by financial integration, economic crises and policy responses. In the early stages of EMU, growing financial integration led to an increase in cross-border holdings of government debt. The GFC and the euro area sovereign debt crisis led to a sharp reduction of portfolio investment away from euro area countries that were perceived to be under stress, amplifying the feedback loops between sovereigns and banks, as the financial health of banks and sovereigns is intertwined. The importance of OFCs in financing government debt has also grown over time as structural and institutional changes (e.g. population ageing and the establishment of funded pension pillars) have contributed to the increase of investment in pension and life insurance products. Finally, the Eurosystem’s purchases of government securities have contributed to the reduction in the share of non-resident and bank holdings of government debt, which started in 2015.

The share of households’ direct and indirect holdings of government debt is significant and has also evolved. The share of government debt held directly by households is relatively low in the euro area as a whole (2% in the third quarter of 2020), but it is higher in several euro area countries and in other advanced economies, reflecting notably institutional differences and supply policies (e.g. the issuance of specific retail bonds or savings notes). However, the role of households in financing government debt goes beyond direct holdings. Considering indirect holdings through IFs and through ICPFs, the role of households in financing the government debt is more significant in most euro area countries (almost 16% in the third quarter of 2020).