Foreign Investor Trading and Spillovers to Local-currency Bond Markets in SEACEN Economies: A Case Study Approach

Over the last two decades, emerging market economy (EME) governments have borrowed substantially from foreign, namely non-resident, investors in local currencies. This signifies progress towards overcoming the so-called “original sin†, namely the inability of a country to borrow abroad in its own currency, which would allow EMEs to mitigate their own exchange rate risks. Such foreign participation in the local-currency (LC) government bond markets can potentially bring additional benefits by greatly enlarging the pool of potential investors, thus reducing the governments’ borrowing costs. However, their participation can also possibly destabilise the markets by transmitting shocks to external/global factors through volatile capital flows. The broad aim of this report is to better understand the mechanism of the spillover effects particularly to emerging economies affiliated with South East Asian Central Banks (SEACEN), and draw some policy insights on how the governments can mitigate possible destabilising impacts while retaining benefits from the foreign participation. To this aim, the innovation of this report is to conduct a country case study of SEACEN economies. This approach has merit as a complement to cross-country analysis that assumes a degree of homogeneity, given that the transmission mechanism is inherently complex, interlinked with various country-specific factors such as bond market structure, regulatory framework, and macroeconomic fundamentals. This report covers the following seven SEACEN economies: Malaysia, Thailand, South Korea, Chinese Taipei, Indonesia, Vietnam, and Cambodia (in the order of appearance). Altogether, the analyses indicate that foreign investor trading does have the potential to transmit shocks to global factors, such as global risk aversion and external interest rates, to the LC government bond markets of emerging SEACEN economies. However, they also suggest that country-specific factors including the foreign investor composition of the market (e.g., mutual funds vs insurance companies/pension funds), macroprudential policy framework to regulate capital flows, and macroeconomic fundamentals such as foreign exchange reserves may all be interlinked with the spillover effects of global shocks to LC government bond markets. Further, some consistent findings are that foreign mutual funds, in particular, play a key role in transmitting global shocks to LC government bond markets, while expectation of LC depreciation generally has a significant impact on foreign investor trading. Hence, acknowledging a usual caveat of a case study approach that external validity is rather limited, the analyses suggest the following policy recommendations: 1. It is useful to closely monitor the foreign investor composition, since certain types of investors have a disproportionate impact on the market stability. 2. Relatedly, it is important to diversify the investor base in preparation for the possibility of global shocks, not relying too much on borrowing from foreign mutual funds. 3. It helps to develop macroprudential tools in the form of capital controls on inflows, to manage possible volatility of flows in times of shocks. 4. It appears to matter to strengthen macroeconomic fundamentals, including the accumulation of foreign exchange reserves in normal times. 5. It helps to develop FX derivatives markets, given that foreign investors, rather than domestic governments, face exchange rate risks in the EME LC markets, because they seek to maximise the value of their portfolios measured in foreign currency.