Emerging market local currency bond yields and foreign holdings – A fortune or misfortune?

Abstract

The paper shows that foreign holdings of local currency government bonds in emerging market countries (EMs) have reduced bond yields but have somewhat increased yield volatility. Econometric analyses conducted from a sample of 13 EMs demonstrate that these results are robust and causal. We use an identification strategy exploiting the geography-based measure of EMs financial remoteness vis-à-vis major offshore financial centers as an instrumental variable for the foreign holdings variable. The results also show that, in countries with weak fiscal positions, foreign holdings are greatly associated with increased yield level. A case study using Poland data elaborates on the cross country findings.