Limited Arbitrage in the Market for Local Currency Emerging Market Debt

Emerging markets governments increasingly rely on local currency denominated debt. Despite this recent development, the markets for foreign and local currency debts exhibit a substantial degree of segmentation. This paper investigates the causes and the consequences of market segmentation for debt prices and debt issuance. First, we show that deviations from the covered interest rate parity condition between local and foreign currency denominated debt are related to market segmentation. Second, we show that the demand for local currency debt from foreign investors is persistent and increases after an improvement in the relative credit rating vis-a-vis foreign currency denominated debt. We propose a simple model of partially segmented markets that replicates the observed empirical regularities. The model predicts that the covered interest rate parity hold only for perfectly integrated markets.