Local Currency Sovereign Bonds Research Articles

Good-bye original sin, hello risk on-off, financial fragility, and crises?

We analyze the sovereign bond issuance data of eight major emerging markets (EMs) - Brazil, China, India, Indonesia, Mexico, Russia, South Africa and Turkey from 1970 to 2018. Our analysis suggests that (i) EM local currency bonds tend to be smaller in size, shorter in maturity, or lower in coupon rate than foreign currency bonds; (ii) EMs are more likely to issue local-currency sovereign bonds if their currencies appreciated before the global financial crisis of 2008 (GFC); (iii) inflation-targeting policy increases the likelihood of issuing local-currency debt before GFC but not after; and (iv) EMs that offer higher sovereign yields are more likely to issue local-currency bonds after GFC. Future data will allow us to test and identify structural changes associated with the COVID-19 pandemic and its aftermath.

Bond Risk Premia and The Exchange Rate

AbstractIn emerging market economies, currency appreciation goes hand in hand with compressed sovereign bond spreads, even for local currency sovereign bonds. This yield compression comes from a reduction in the credit risk premium. Crucially, the relevant exchange rate involved in yield compression is the bilateral U.S. dollar exchange rate, not the trade‐weighted exchange rate. Our findings highlight endogenous co‐movement of bond risk premia and exchange rates through the portfolio choice of global investors who evaluate returns in dollar terms.

Can the Chinese domestic bond and stock markets facilitate a globalising renminbi?

A global renminbi (RMB) needs to be backed by a large, deep and liquid RMB market with a world-class Chinese government bond (CGB) market as its core. It also needs the support from a bigger and more open domestic stock market. China’s CGB market is the sixth largest local currency sovereign bond market in the world. By transforming the non-tradable, captive central bank liabilities into homogeneous and tradable CGBs through cutting the still high Chinese reserve requirements by 1/3, the size of the CGB market can rise by 40%, boosting market liquidity while trimming distortions to the banking system. Also, policy bank bonds may attract foreign investor demand. Finally, a bigger and more open domestic A-share stock market also helps expand the RMB assets in the international investor portfolio. With both bigger bond and stock markets and their higher foreign ownerships following market opening, the combined sum of Chinese domestic bonds and A-shares held by foreign investors may increase five folds during 2018–2025, lifting the RMB asset position in global investor portfolios, facilitating a potential global RMB, while promoting a deeper and more efficient Chinese domestic capital market. This process of liberalising cross-border portfolio capital flows for non-resident investors may bring both risks and benefits to the Chinese economy.

Local Currency Bond Returns in Emerging Economies and the Role of Foreign Investors

Foreign investors play a key role in sovereign bond markets in emerging market economies (EMEs), in part because their portfolio flows are sensitive to bond returns and are therefore pro-cyclical in nature. This note discusses the implications of the framework proposed by So et al (2019), which incorporates the risk that arises from the portfolio performance and flows of actively managed bond funds. When the framework is applied to the data, using local currency sovereign bonds of 16 EMEs, preliminary calculations show that local currency sovereign bonds that positively covary with the returns of active funds receive risk premia as compensations for active fund risk. Furthermore, and in line with theory, the price of this risk increases when bond funds experience outflows and the exposure to active funds risk increases with the heightened price of risk. This double effect helps explain why spikes in returns of some EME local currency bonds can be especially large. These results demonstrate how the portfolio performance and flows of actively managed funds help transmit shocks across EMEs. Full Publication: Asia-Pacific Fixed Income Markets: Evolving Structure, Participation and Pricing

Emerging market local currency sovereign bond yields: The role of exchange rate risk

This paper explores the role of exchange rate risk in determining local currency sovereign bond yields in emerging market economies (EMEs). We find that EME local currency sovereign bond yields are indeed influenced by exchange rate risk (volatility and expected depreciation of the exchange rate). This finding holds when controlling for endogeneity and a number of key domestic and international factors. We also show that the effect of exchange rate volatility has strengthened over time, particularly since the US Federal reserve announced in May 2013 that it would reduce the pace and size of its large-scale asset purchases. The influence of exchange rate volatility is less pronounced in EMEs with higher shares of foreign ownership of local currency sovereign bonds, larger capital account openness and greater exchange rate flexibility. Our findings have a number of implications for policymakers, in particular as to how emerging market economies can be vulnerable to perception of greater exchange rate risk as global monetary conditions tighten.

Localising sovereign debt: The rise of local currency bond markets in sub‐Saharan Africa

AbstractThis paper analyses the development of local currency sovereign bond markets (LCBMs) in sub‐Saharan Africa (SSA), a potentially important source of longer‐term public finance. We make two contributions to the literature. First, we build a novel data set comprising 28 SSA countries for the period 2000–14 to uncover the main correlates of LCBM capitalisation, of local currency bond (LCB) tenors and of LCB issue yields. We find that LCBM capitalisation in SSA relates to politico‐institutional factors, overall financial development and financial system structure. For LCB tenors and issue yields, inflation levels matter too. Second, we complement our econometric analysis with qualitative case studies of Kenya and Nigeria, where we further investigate the drivers of LCBM development and place LCBMs in a broader public debt context. While we document the increasing importance of LCBMs in SSA, we also highlight new vulnerabilities, including those related to investor base composition.

Spillovers from U.S. Monetary Policy Normalization on Brazil and Mexico's Sovereign Bond Yields

This paper examines the transmission of changes in the U.S. monetary policy to localcurrency sovereign bond yields of Brazil and Mexico. Using vector error-correction models, we find that the U.S. 10-year bond yield was a key driver of long-term yields in these countries, and that Brazilian yields were more sensitive to U.S. shocks than Mexican yields during 2010–13. Remarkably, the propagation of shocks from U.S. long-term yields was amplified by changes in the policy rate in Brazil, but not in Mexico. Our counterfactual analysis suggests that yields in both countries temporarily overshot the values predicted by the model in the aftermath of the Fed’s “tapering” announcement in May 2013. This study suggests that emerging markets will need to contend with potential spillovers from shifts in monetary policy expectations in the U.S., which often lead to higher government bond interest rates and bouts of volatility.

Spillovers from U.S. Monetary Policy Normalization on Brazil and Mexico's Sovereign Bond Yields

This paper examines the transmission of changes in the U.S. monetary policy to localcurrency sovereign bond yields of Brazil and Mexico. Using vector error-correction models, we find that the U.S. 10-year bond yield was a key driver of long-term yields in these countries, and that Brazilian yields were more sensitive to U.S. shocks than Mexican yields during 2010–13. Remarkably, the propagation of shocks from U.S. long-term yields was amplified by changes in the policy rate in Brazil, but not in Mexico. Our counterfactual analysis suggests that yields in both countries temporarily overshot the values predicted by the model in the aftermath of the Fed’s “tapering” announcement in May 2013. This study suggests that emerging markets will need to contend with potential spillovers from shifts in monetary policy expectations in the U.S., which often lead to higher government bond interest rates and bouts of volatility.

A Regional Factor Approach to Project Term Structures of Emerging Local Currency Sovereign Bonds

Abstract To project term structures for a comprehensive set of emerging local currency sovereign bond markets, we propose to extend the dynamic Nelson-Siegel term structure model with regional and economy-specific factors. In the presence of comparably short data histories for most emerging bond markets, this approach results in yield curve projections consistent across markets and in line with historical experience.

Global Financial Spillovers to Emerging Market Sovereign Bond Markets

Foreign holdings of emerging markets (EMs) government bonds have increased substantially over the last decade. While foreign participation in local-currency sovereign bond markets provides an additional source of financing and reduces sovereign yields, it raises concerns about increased sensitivity of yields to shifts in market sentiment. The analysis in this paper suggests that foreign participation and an undiversified investor base transmit global financial shocks to local-currency sovereign bond markets by increasing yield volatility and, beyond a certain threshold, amplify these spillovers. These estimates are robust to a range of econometric techniques including panel smooth threshold regression.

Global Financial Spillovers to Emerging Market Sovereign Bond Markets

Foreign holdings of emerging markets (EMs) government bonds have increased substantially over the last decade. While foreign participation in local-currency sovereign bond markets provides an additional source of financing and reduces sovereign yields, it raises concerns about increased sensitivity of yields to shifts in market sentiment. The analysis in this paper suggests that foreign participation and an undiversified investor base transmit global financial shocks to local-currency sovereign bond markets by increasing yield volatility and, beyond a certain threshold, amplify these spillovers. These estimates are robust to a range of econometric techniques including panel smooth threshold regression.