Push into local bond markets stores up potential trouble
Foreigners own about 40% of US$19trn local currency debt
For 20 years, the International Monetary Fund and World Bank preached the virtues of local bond markets.
Lessons from the Mexican, Russian and Asian crises of the 1990s were clear: countries couldn’t rely on global pools of capital; local markets were the only real source of reliable funding.
Many countries have heeded that advice. Today, unlike in the 1990s, the vast majority of borrowing is done at home. The shift has been greatest in emerging markets, where governments and corporates today have US$19trn of local currency bonds outstanding, dwarfing the US$2.8trn of international debt.
But growth of local markets has in many places been lopsided, warped by the glut of liquidity that has distorted the global financial system since the 2008 crisis. Concerns are growing that the push towards local markets may have been premature, and in some places has created fresh vulnerabilities.
“The IMF and the World Bank have basically been encouraging local currency borrowing,” said Kaushik Rudra, global head of rates and credit research at Standard Chartered and a former World Bank economist. “They have gone around the world talking about that – which is fine, it makes sense.”
“But countries also need to develop the right framework, with a deeper and more structural onshore buyer base. That hasn’t always happened. The reliance on foreign investors shouldn’t be as high as it is in some countries and makes them vulnerable to sentiment swings and bouts of risk aversion.”
As local bond markets have grown over the past decade, so too has the role of foreign money. JP Morgan estimates that foreign ownership of local currency bonds was only 11% in 2009, when the overall size of markets was much smaller. Now, foreign ownership is around a third - and as high as 60% in some places.
Quantitative easing and a global liquidity glut have contributed, as has the development of mutual funds focused on EM local currency debt. The Templeton Emerging Markets Bond Fund, one of the largest with about US$10bn of assets, owns big chunks of Argentinian, Egyptian and Ghanaian local debt, for instance.
The concern is that some countries have increased their pace of local bond sales before developing a domestic buyside of pension and insurance funds that many see as essential to the long-term stability of such markets. That could leave them vulnerable if foreigners take flight.
“Some countries have been successful in developing these markets,” said Daniel Hardy, capital markets division chief at the IMF. “However, experience is diverse. It is important to disaggregate global figures to see what is happening in different countries, and in particular to look beyond the very largest EMs.”
“Often the most common challenge is to develop a domestic investor base. There are countries that might have a short history, have little financial savings, and few long-term saving institutions.”
In such instances an over-reliance on foreign buyers could create problems for sovereigns and corporates, especially when the time comes to roll over or refinance debt.
As rates rise in the developing world, the IMF is monitoring flows for potential signs of stress.
“We are very aware that emerging markets can be subject to episodes of turmoil and shifts in sentiment … it is clearly a potential risk,” said Hardy. “It is our job in the Fund to look for potential disequilibria … and that might include foreign investors in the local currency bond markets.”
Over-reliance on local currency debt can also limit options in an acute crisis. External debt creates the option to default without destroying the local banking system. Without that, governments might simply choose to print money and inflate away the debt – something that might be worse for the local economy.
“A default on external debt without creating a ton of inflation might be better for the local population,” said Dirk Willer, head of emerging market strategy at Citigroup. “Debt relief on an external default is often around 70%: you’d have to drive inflation up by huge amounts to achieve similar relief.”
Another risk is that countries could stop capital from fleeing.
“One possible endgame in these cases where funding dries up is always capital controls, which would leave foreign investors unable to get their money out,” said Willer. “A lot of countries have soft capital controls, often endorsed by the IMF, but then there are severe capital controls. For sure, that risk exists.”
Of course, while such risks are real, it is also true that foreign inflows have so far often had a positive impact on EM countries. The cost of funding has fallen dramatically for many. And many countries have made giant leaps in their market infrastructure in a bid to attract foreign money.
“These markets now have more access to funding than they ever have before,” said Rudra. “We’ve come a long way since the 1990s, when many countries struggled to get anything at all. So these countries are better off for that. But it has also increased vulnerability. Many of these markets are untested.”