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This paper estimates the impact of foreign participation in determining long-term local currency government bond yields and volatility in a group of emerging markets from 2000-2009. The results of a panel data analysis of 10 emerging markets show that greater foreign participation in the domestic government bond market tends to significantly reduce long-term government yields. Moreover, greater foreign participation does not necessarily result in increased volatility in bond yields in emerging markets and, in fact, could even dampen volatility in some instances.
Malaysia’s local currency debt market is one of the most liquid public debt markets in the world. In recent years, the growing share of nonresident holders of debt has been a source of concern for policymakers as a reason behind exchange rate volatility. The paper provides an overview of the recent developments in the conventional debt market. It builds an empirical two-stage model to estimate the main drivers of debt capital flows to Malaysia. Finally, it uses a GARCH model to test the hypothesis that nonresident flows are behind the observed exchange rate volatility. The results suggest that the public debt market in Malaysia responds adequately to both pull and push factors and find no firm evidence that nonresident flows cause volatility in the onshore foreign exchange market.
Countries that cannot attract foreigners to invest in their local currency bonds run the risk of currency mismatches that can result in painful crises. We analyze foreign participation in the bond markets of over 40 countries. Bond markets in less developed countries have returns characterized by high variance and negative skewness, factors that we show are eschewed by U.S. investors. While results based on a three-moment CAPM indicate that it is diversifiable idiosyncratic risk that U.S. investors shun, our analysis suggests that countries can improve foreign participation by reducing macroeconomic instability.
This guidance note was prepared by International Monetary Fund (IMF) and World Bank Group staff under a project undertaken with the support of grants from the Financial Sector Reform and Strengthening Initiative, (FIRST).The aim of the project was to deliver a report that provides emerging market and developing economies with guidance and a roadmap in developing their local currency bond markets (LCBMs). This note will also inform technical assistance missions in advising authorities on the formulation of policies to deepen LCBMs.
In November 2011, the G-20 endorsed an action plan to support the development of local currency bond markets (LCBM). International institutions—the IMF, the World Bank, the EBRD, and the OECD—were asked to draw on their experience to develop a diagnostic framework (DF) to identify general preconditions, key components, and constraints for successful LCBM development. The objective is to provide a tool for analyzing the state of development and efficiency of local currency bond markets. The application of the DF is expected to be flexible, bearing in mind that the potential for LCBM development depends on economic size, financing needs, and stage of economic development.
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 in the post-Lehman period. Econometric analyses conducted from a sample of 12 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 and external positions, foreign holdings are greatly associated with increased yield volatility. A case study using Poland data elaborates on the cross country findings.
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.
We assess the extent to which emerging economies have been able to attract global investors to their local currency bond markets. To do so, we first provide a sense of the playing field by examining the surge in the development of local currency bond markets over the past decade, as well as the historical returns characteristics faced by global investors. We then present a model in which investors care about barriers to investment as well as the mean, variance, and skewness of expected returns. Empirical tests suggest that the dominant factor is a new measure of investability; cross-border participation in local currency bonds is highest in countries in which investor-friendly institutions and policies have been established. Finally, we discuss the link between our findings and global financial stability. In particular, both increased bond market development and greater foreign participation are paths toward ameliorating imbalances associated with 1990s and more recent financial crises.
Local currency bond markets in ASEAN+3 play an important role in diversifying financial intermediary channels and mitigating the impacts of financial crises. They also have the potential to help mobilize developing Asia's significant savings to meet the region's enormous infrastructure investment needs. Drawing extensively on knowledge generated by the ASEAN+3 Bond Market Forum, the publication looks at the essential building blocks and the enabling environment for these markets, as well as the roles of government, relevant authorities, and market participants.