A global currency war rages, China slaps tariffs on US poultry, and the US Congress considers punitive measures related to the USD-RMB peg — suffice to say that complications related to global imbalances won’t be resolved anytime soon.
But let’s look at the long term. Economists John Burger, Veronica Warnock, and Francies Warnock have written a new paper bolstering the case that the development of local-currency bond markets in emerging economies would be extremely helpful.
One of the several drivers of global imbalances (that we’ve previously discussed) is the demand for rich-country financial assets by emerging country savers and governments, who lack better options within their own countries’ underdeveloped markets.
And it’s well-known that currency mismatches played a big role in the EM financial crises of the 1990s. The main policy response by emerging markets was to accumulate big stores of foreign currency (USD) reserves.
Although the authors find that EM financial markets remain underdeveloped and that currency mismatches persist, it’s a good sign that decent progress was made from 2001-2008, with local-currency bonds accounting for an increasingly larger share of their total domestic fixed income markets.
They write (emphasis ours in all excerpts):
Local currency bond markets have grown in size relative to GDP and emerging economies have become much less reliant on foreign-currency-denominated bonds. The data in Table 3a suggest that emerging economies are not predestined to rely on foreign currency borrowing and do in fact have the capacity to develop local currency bond markets. For example, whereas in 2001 Latin American bonds were about half in the local currency and half in foreign currencies, by 2008 over 70 percent of their outstanding bonds were local-currency denominated. Importantly, the reduced reliance on foreign currency borrowing has not been replaced by a greater reliance on short-term borrowing. Table 3b indicates that average local currency bond maturities have generally increased over the past decade, with impressive lengthening in Latin America. We therefore find no evidence that currency mismatches have been replaced by maturity mismatches.
Developing these markets obviously takes time, but the payoff, say the authors, would be not only more stability for these economies, but greater global stability. These markets would help to mitigate the unnatural flow of capital from low-income to high-income countries that Martin Wolf constantly points out (most recently on Wednesday).
As for how the attractiveness of these bonds to global investors has changed in the last decade, there are hopeful signs there too, write the authors:
The recent returns characteristics for emerging market bonds are far more favorable than those for previous periods. As Burger and Warnock (2007) showed, in the period ending 2001 emerging market bonds were much more volatile and exhibited significantly more negative skewness than advanced economy bonds, whether returns were assumed to be hedged or not. In that study they opined that the fact that less developed bond markets were characterized by higher variance and more negative skewness highlighted a distinct difference between emerging market and advanced economy bonds: Periods of negative bond returns for emerging markets did not coincide with currency appreciations. To the contrary, periods of rising interest rates often occurred during an episode of financial flight and currency depreciation—the makings of a currency crisis. In contrast, in the Naughties, a greater number of emerging markets have achieved improved policy stability and thus have been more successful in eliminating the joint bad outcomes (from the perspective of a global bond investor) of losses on bonds and a depreciating currency.
Finally, it’s interesting to note that it isn’t the diversification and return characteristics of these markets that matter most to investors, but rather their investability:
We find some evidence that U.S. investors‘ bond portfolios are tilted toward markets that provide more potential diversification benefits and in which the expected mean and skewness of returns are more positive, but by far our strongest and most robust result is related to (the lack of) direct barriers to international investment: Countries with investor-friendly institutions and policies—specifically, fewer capital controls, greater market liquidity and efficiency, stronger regulatory quality and creditor rights, better market infrastructure, lower taxation, and a larger local institutional investor base—attract more U.S. investment. To the extent countries want to be able to borrow internationally in their currencies, these results point to concrete measures to be addressed in further financial sector development.
Fostering this kind of financial market development is laborious and takes time, and we certainly don’t think it can help with the immediate policy dilemmas.
But, to repeat ourselves, neither should it be ignored.
Related links:
Investing in local currency bond markets – NBER
Global imbalances and EM financial markets – FT Alphaville