Emerging Local Currency Bond Markets

In this article, the authors assess local currency bond markets in emerging market economies (EMEs). Supported by policies and laws that helped improve macroeconomic stability and creditor rights, local currency EME bond markets have grown substantially over the past decade and have provided USD-based investors with attractive returns. U.S. investors have responded by sharply increasing their holdings of EME local currency bonds, especially in EMEs with investor-friendly institutions and policies.In this article, we characterized the development of emerging market economy (EME) local currency bond markets, focusing on their size, fundamental factors that enable their growth, and the returns they have produced for USD-based investors. We showed that EME local currency bond markets have grown sharply over the past decade and, importantly, their growth has reduced EMEs’ reliance on foreign currency debt. Although growth in EME local bond markets has been relatively broad based, we found that EMEs with lower inflation volatility and stronger legal rights are better able to develop local currency bond markets. We also showed that this growing asset class has provided USD-based investors with attractive return characteristics over the past decade.U.S. investors have responded to these favorable developments. U.S. holdings of local currency bonds increased in almost every EME in our sample, with aggregate bond holdings in EMEs increasing from less than $2 billion in 2001 to more than $27 billion in 2008. Some EMEs received more investment than others; we found that U.S. bond portfolios are tilted toward markets that provide more potential diversification benefits (i.e., markets that have a lower correlation with U.S. bonds) and in which the expected mean and skewness of returns are more positive. We also found that countries with investor-friendly institutions and policies—specifically, fewer capital controls, greater market liquidity and efficiency, stronger regulatory quality and creditor rights, better market infrastructure, lower taxation, and a larger local institutional investor base—attract more U.S. investment.Our work suggests a handful of fundamental factors that investors should watch as they assess EME local currency bond markets. On the supply side, investors should track the evolution of legal rights for creditors. Creditor rights remain quite limited in many of the largest EMEs; improvement on this front will support additional expansion in EME bond markets, whereas any backsliding will decrease investor demand. Investors should also be mindful of the recent surge in inflation across EMEs, which could jeopardize the progress in local bond market development. On the one hand, if the recent increase in inflation is contained, it would support further growth in these markets and could signal a continuation of the decade-long attractive returns. On the other hand, if the hard-earned macroeconomic stability is lost and EMEs move into a more volatile, high-inflation environment, both local and global investors will shun these markets. Finally, cross-border investors should also keep an eye on the investability measures that we showed are linked to increased U.S. investor holdings of local currency bonds.