The Global Financial Crisis has heightened policymakers' focus on understanding how rising non-performing loans affect fiscal policy, particularly through their effect on stock-flow adjustments. Consequently, there is a growing interest in exploring the interaction between financial instability and public debt dynamics. This research is especially significant as it unveils a new connection between financial sector vulnerabilities and the sustainability of public debt.
Using panel data from 69 countries (2008–2020) and applying the Jordà (2005) local projection methodology.
We find that increasing NPL ratios lead to a significant increase in stock-flow adjustment (SFAs) over the medium-term. This reflects the build-up of public debt that cannot be directly attributed to budget deficits but is due to government measures to prop up a troubled bank or banking system.
Our analysis examines for the first time in the literature the dynamic response of SFAs to increases in NPLs over a medium-term horizon.
