Publication 07 Apr. 2020 - Emerging market economy exchange rates and local currency bond markets amid the Covid-19 pandemic Boris Hofmann, Ilhyock Shim and Hyun Song Shin
Emerging market economy exchange rates and local currency bond markets amid the Covid-19 pandemic
Key takeaways
• Borrowing through domestic currency bonds has not insulated emerging market economies (EMEs) from the financial shock unleashed by Covid-19; EME local currency bond spreads spiked amid sharp currency depreciations and capital outflows.
• Portfolio investors face amplified losses as local currency spreads and exchange rates move in lockstep; their revised portfolio allocations in turn strengthen this correlation.
• EMEs with monetary policy frameworks that are equipped to address the feedback loop between exchange rate depreciation and capital outflows stand a better chance of weathering the financial fallout from the Covid-19 pandemic
. • To counter large stock adjustments in domestic bond markets, EME central banks may need to expand their toolkit to take on a “dealer of last resort” role; a number of them are already moving in this direction.
The Covid-19 pandemic has sparked widespread and synchronised recoiling from risk that has hit emerging market economies (EMEs) particularly hard. The focus of this Bulletin is on local currency bond markets. Borrowing in domestic currency has not insulated EMEs from currency movements, as sharp currency declines have set in motion amplifying dynamics in the financial system between record portfolio outflows in EME bonds (Graph 1, left-hand panel) and the spike in EME local currency bond spreads over international benchmarks (right-hand panel).
These recent events have exposed in a particularly stark way the financial channel of the exchange rate (BIS (2019)), ie the amplifying and mutually reinforcing interactions of currency fluctuations and financial market outcomes in EMEs, particularly in EME local currency bond markets. This article lays out the key mechanisms of this channel and how they have played out in recent weeks. We also draw lessons for EME central banks and for their monetary policy frameworks as they weather the financial fallout from the Covid-19 pandemic.
1 Weekly data across major emerging market economies (EMEs) and selected advanced economies (AEs) (Canada and the United Kingdom) up to 18 March 2020 from EPFR. Data cover net portfolio flows (adjusted for exchange rate changes) to dedicated funds for individual EMEs and selected AEs and to EME funds with country/regional decomposition. 2 Simple averages of EMEs excluding China. An increase indicates USD appreciation. 3 Spread between the yield of the GBI-EM Broad index excluding China, 7–10 years, over benchmark US Treasury yield.
Sources: Bloomberg; EPFR; national data; BIS calculations.
“Original sin redux”
A key lesson from the EME financial crises of the 1990s was that currency mismatches combined with maturity mismatches gave rise to a vulnerability to capital outflows. In reaction, EMEs developed local currency bond markets in long maturities to overcome so-called “original sin”, of not being able to borrow internationally in their domestic currency (Eichengreen and Hausmann (1999)). While EME corporates still rely on foreign currency credit, EME sovereigns have increasingly turned to local currency issuance. Indeed, local currency bond markets in EMEs now represent the lion’s share of outstanding bonds in EMEs.
Owing to their smaller domestic institutional investor base, EME bond markets have relied on external portfolio investors for their growth (Graph 2, left-hand panel). If these investors evaluate gains and losses in terms of dollars or other advanced economy currencies, unhedged holdings of EME local currency bonds increase the risk exposure for the investors, giving rise to a potentially greater sensitivity of holdings to shifts in measured risks. As a consequence, reliance on foreign external portfolio capital leads to a greater vulnerability to global financial shocks, as such capital can be more flighty in times of stress (HKMA (2019)). Indeed, EMEs with higher shares of foreign ownership in their local currency bond markets have experienced significantly larger increases in their local currency bond spreads in the wake of the Covid-19 pandemic (Graph 2, right-hand panel).
The exchange rate plays an important amplifying role in the portfolio adjustment of global investors. Borrowing in local currency from foreign lenders mitigates currency mismatch for the borrower but shifts the currency mismatches to the lender’s balance sheets ‒ a phenomenon dubbed “original sin redux” by Carstens and Shin (2019), and explained further in BIS (2019). The lenders have assets in foreign currency but obligations to beneficiaries or policyholders in their own currency. In this context, a generalised EME currency depreciation further lowers the value of assets in the foreign investors’ home currency terms, tightening their risk constraints more than otherwise. When risk capacity is limited, EME currency depreciation may trigger sales or ex post hedging, pushing up EME bond spreads due to the exit of foreign investors. The same mechanism plays out in reverse when EME exchange rates appreciate. The gains to foreign investors are amplified by EME currency appreciation, leading to inflows.
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