The Bank for International Settlements (BIS) today released a BIS Bulletin entitled “Emerging Market Economy Exchange Rates and Local Currency Bond Markets Amid the Covid-19 Pandemic” written by staff members Boris Hofmann, Ilhyock Shim and Hyun Song Shin.
Among the key findings in the report, the authors say portfolio investors face amplified losses as local currency spreads and exchange rates move in lockstep; borrowing through domestic currency bonds has not insulated emerging market economies (EMEs) from the financial shock unleashed by Covid-19; 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; and, in order 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.
The Covid-19 pandemic has sparked widespread and synchronised recoiling from risk that has hit emerging market economies (EMEs) particularly hard, the authors note. “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),” the report states.
These recent events have exposed in a particularly stark way, the financial channel of the exchange rate (ie, the amplifying and mutually reinforcing interactions of currency fluctuations and financial market outcomes in EMEs, particularly in EME local currency bond markets).
“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 a so-called “original sin”, of not being able to borrow internationally in their domestic currency. 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., the report notes.
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). The authors suggest that 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, the report says. Indeed, it continues, 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 authors note. 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.
The authors note that the close relationship between exchange rates and local currency bond prices can be seen by comparing the returns of bond funds in local currency terms and in US dollar terms (Graph 3). For EME bonds, US dollar returns are more sensitive to yield changes than local currency returns. The relationship between exchange rates and yields in the most recent period (Graph 3, top right-hand panel) has conformed to the general pattern observed over a longer period of time (top left-hand panel). The “duration” of EME bonds (defined as the sensitivity of the bond return to shifts in the yield) tends to be larger in dollar terms than in local currency terms.
“For investors that evaluate returns in dollar terms, EME bonds thus have the duration risk of much longer maturity bonds, as exchange rate moves tend to amplify investors’ gains and losses. In this sense, exchange rate changes reinforce the impact of yield changes, in turn amplified by capital flows,” the authors state. “For advanced economies, by contrast, duration in local currency terms was higher than in US dollar terms in the pre-Covid-19 period (Graph 3, bottom left-hand panel), suggesting that here the exchange rate dampened the impact on investor returns. However, ever since the Covid-19 outbreak started going global, bond returns in advanced economies have displayed a pattern more similar to that in EMEs (bottom right-hand panel).”
The procyclical mechanism laid out above is one key reason why EME sovereign spreads tend to increase when the currency of the issuer depreciates (Graph 4, left-hand panel). It has played out forcefully since 2013, a period characterised by a large depreciation of many EME currencies against the US dollar, including during the taper tantrum period, the report notes.
The authors further note that the procyclical mechanism is also borne out in formal empirical analysis (see right-hand panel of Graph 4). “A depreciation of EME currencies against the US dollar is followed by a significant increase in local currency bond spreads, driven by higher credit risk premia. Quantitatively, a 1% depreciation shock leads to an increase in EME bond spreads of up to 9 basis points. This implies that the 10% depreciation of EME currencies that we have seen since early March could expand EME spreads by up to 90 basis points, which compares with an actual increase in EME spreads of roughly 150 basis points since mid-February (Graph 1, right-hand panel),” the report states.
The role of sound policy frameworks
The Covid-19 pandemic will be a stress test for EME central bank market operations and monetary policy frameworks, the authors acknowledge.. In order to meet the challenges posed by large swings in capital flows and exchange rates, many EMEs have adopted policy frameworks that combine inflation targeting with macroprudential tools and FX reserve accumulation. These frameworks have brought welcome stability and should help EMEs weather the Covid-19 fallout. “Better anchored inflation expectations will mitigate the impact of exchange rate depreciation on inflation,” the authors add. “Macroprudential policies also enhance the resilience of the financial system. Many EMEs have accumulated large FX reserves over the past decade (Graph 5, left-hand panel). These FX reserves can buffer the shocks from the Covid-19 crisis and alleviate financial stress on EMEs, as they enable central banks to lean against currency depreciation and capital outflows. In the wake of the taper tantrum, EMEs with larger reserves experienced smaller currency depreciations (right-hand panel). The same is likely to be true this time round.”
Yet, in order to meet the challenge of large stock adjustments by global investors, EME central banks may need to expand their toolkit, taking up the role of a dealer or buyer of last resort, the authirs suggest. “In particular, they may need to deploy their balance sheets by providing targeted liquidity to market participants, by intermediating in the repo market or by purchasing domestic bonds. EME central banks are already adapting and moving fast in this direction. For instance, the central banks of Colombia, the Philippines, Poland and South Africa recently launched bond purchase programmes, while the Bank of Thailand introduced a mutual fund liquidity facility.
Sound policy frameworks at the national level can be supported by credible and effective global and regional financial safety nets, reinforced by short-term liquidity support and bilateral lines from other central banks, the authors say. The swap and repo facilities recently announced by the Federal Reserve have eased dollar funding conditions, they note.
“Given the ‘dual’ nature of the problem – with spreads and exchange rates spiralling in tandem – dollar lines will also quell domestic financial stringency. From a longer-term perspective, the development of a deep domestic institutional investor base will be key to further reducing EMEs’ vulnerability to external financial shocks, such as the fallout from the Covid-19 pandemic that is now materializing,” they conclude.
The views expressed are those of the authors and not necessarily the views of the BIS.