Journal Issue

Global Bond Markets: Emerging Markets Weather Fallout from Financial Crisis

International Monetary Fund. External Relations Dept.
Published Date:
June 2008
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Despite the severe fallout from the subprime meltdown that is dampening world growth and depressing financial markets, emerging market countries are weathering the financial crisis relatively well, according to participants at the 10th annual Global Bond Market Forum.

“Emerging market economies so far have proven to be broadly resilient,” IMF First Deputy Managing Director John Lipsky told the April 29-30 forum, jointly hosted by the Organization for Economic Cooperation and Development (OECD), the World Bank, and the IMF. It was held this year in Washington, D.C.

But Lipsky added that heightened risk aversion and liquidity retrenchment from the ongoing turbulence in global capital markets has affected financial markets in emerging economies through higher volatility, increased risk reflected in higher yields, and sharply lower bond issuance—although conditions varied widely across countries.

“These developments clearly demonstrate the interdependence of both risks and their transmission in an increasingly integrated global financial market,” Lipsky said.

Jaime Caruana, Director of the IMF’s Monetary and Capital Markets Department, said emerging markets had done well despite the dislocation in credit and funding markets, particularly in the United States, because of their improved economic and fiscal policies, high external liquidity positions, robust current account surpluses, and strong growth.

Emerging market governments and many companies have used the favorable market and external conditions of the past five years to improve their capacity to weather a drought of external capital. Central bank reserves have grown and corporate cash levels remain high.

But Caruana told the conference that emerging market countries are vulnerable to the market turmoil through three main financial channels:

  • The general repricing of credit risks has increased the cost of external financing and reduced the availability of funding.
  • Because of pressure on parent banks in mature markets, funding of subsidiaries in emerging markets could recede, although this so far has not been the case.
  • If growth slows in emerging markets, investment flows could retrench, prompting a sharp correction in equity valuations and increased potential for currency volatility.

The importance of a more complex distribution of liquidity across the financial landscape was underscored by Hans Blommestein, the Head of Debt Management and Bond Markets Program at the OECD.

With investors—including hedge funds—seeking to reduce risk and deleverage, capital markets in emerging economies have already seen a significant drop in the issuance of below-investment-grade credits.

Delegates to the conference noted that global default risks could force up premiums in emerging markets and thus pose the greatest threat to affordable borrowing in these countries.

Going forward, banking sector balance sheet pressures in the United States and the European Union may crimp the ability of emerging corporate borrowers to access funds, meaning that the rollover risk for emerging market syndicated loan amortizations will likely increase. Even if credit quality remains intact, arbitrage factors may raise the cost of borrowing in external markets.

Delegates noted that the first real test of the attractiveness of local market investment in emerging markets will be if the U.S. dollar or global commodity price cycles turn. The main questions for investors continue to be how deep the credit market contraction will be and how long the reduced access to funds will last.

Top 10 markets dominate

The local institutional investor base in emerging markets is growing rapidly. But trading is concentrated in the top 10 markets, which account for 80 percent of total volumes and 84 percent of domestic volumes.

The top 10 emerging economy debt markets are: Mexico, Brazil, South Africa, Turkey, Argentina, Poland, Korea, India, Hungary, and Russia.

Overall liquidity trends in emerging domestic debt markets are improving. There has been a discernible move by foreign investors (including hedge funds) into these local markets, with secondary market liquidity shifting from external debt to local market debt.

Whereas larger trades are still taking place on over-the-counter markets, a shift is under way toward electronic trading platforms, especially for the most liquid assets.

Michael Klein, World Bank Vice President and Chief Economist, noted the capital markets advisory work of the World Bank Group in more than 30 countries and the recently launched Global Emerging Markets Local Currency Bond Program (GEMLOC), which combines the World Bank’s comparative advantage and the private sector to help develop local currency bond markets.

Role of the IMF

During the conference, the IMF highlighted its work in helping foster the deepening of local bond markets in emerging economies. Countries with well-functioning and liquid local bond markets are likely to better cope with shocks and the risks stemming from a protracted global credit crisis.

The IMF is working with member countries to help strengthen regulatory and supervisory frameworks, including in derivatives, repo, and securitization markets. It is also helping improve public debt management and debt market development, while encouraging a broadening and diversification of the local investor base.

The IMF is gleaning important lessons from the current crisis to enrich its policy advice to its member countries. Notably, with the rapid growth of local bond markets in emerging economies, market participants need to have the appropriate incentives to monitor and manage the risks underlying new instruments, while making sure that credit discipline is not weakened.

At the same time, regulatory frameworks need to be reevaluated, taking on board lessons learned from the current difficulties in advanced markets. Inadequate transparency and disclosure by financial institutions can also erode investor confidence and may cause institutions to become far more cautious about counterparty exposures.

Many emerging market countries—such as Brazil, Mexico, Poland, South Africa, Thailand, and Turkey—have made marked progress in implementing reforms to foster the development of local bond markets. Secondary market liquidity has improved in countries that have provided an enabling environment for local bond market development.

The development of repo and derivatives markets has been an important step in countries such as Mexico, Brazil, and Korea. Electronic trading platforms in some of these countries have helped in price guidance.

Private sector perspective

Lipsky briefed the conference on the findings of an IMF working group that was set up to examine private sector perspectives on major impediments to capital market development in emerging economies. The group was established under the auspices of the Fund’s Capital Markets Consultative Group, which liaises with the private sector. The working group’s report is to be finalized by June 2008.

The working group highlights that the high costs of access to some of these markets are symptomatic of the diversity of tax treatments, investment restrictions such as capital controls, and inefficiencies in market infrastructure. It also stresses the importance of easing access to local markets, lowering transaction costs, and broadening the local institutional investor base.

According to the working group, as emerging economies continue to pursue policies to broaden and deepen local capital markets and enhance financial regulations to keep pace with financial innovation, a number of issues will need to be addressed. They include

  • increasing ease of access to local markets and lowering transaction costs;
  • further enhancing liquidity in local government bond markets;
  • enhancing availability of domestic financing;
  • broadening and deepening the local institutional investor base; and
  • harnessing corporate finance (especially corporate bond markets) to meet investor demand.

Mangal Goswami and Ceyla Pazarbasioglu

IMF Monetary and Capital Markets Department

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