Ebook How Have Local Currency Bond Markets In EMEs Weathered The Financial Crisis?
There is an optimistic and a pessimistic reading from the recent crisis on how far local currency bond markets can immunise emerging markets from international financial crises. The optimistic view goes like this. One of the great reforms in Latin America and in developing Asia during the past decade has been the diminished reliance on foreign currency and increased borrowing by governments in local currency and at long maturities. The development of domestic currency bond markets has in many ways been the foundation stone of this progress.
As a BIS report a few years ago argued, balance sheet weaknesses due to currency mismatches had played a key role in virtually every major financial crisis affecting the emerging market economies (EMEs) since the early 1980s. A heavy dependence on foreign currency debt made it impossible to use macroeconomic policies as countercyclical tools. As government interest payments on foreign currency debt rose when the exchange rate fell, governments were forced to raise taxes (or cut other spending) in the face of recession. And monetary policy had to focus not on stabilising the economy but on propping up the exchange rate.
Matters were often made worse by the short duration of much foreign currency debt. Sharp increases in international interest rates, coming on top of currency depreciation, further increased debt servicing costs, worsening creditworthiness. Difficulties in rolling over maturing debt on sustainable terms were compounded. As many EMEs shared similar balance sheet vulnerabilities, crises could reach globally systemic dimensions.
The development of local currency bond markets would reduce such vulnerabilities by eliminating currency mismatches and lengthening the duration of debt. Such markets would also improve economic efficiency by generating market-determined interest rates that reflect the opportunity cost of funds at different maturities (see CGFS (2007) for a fuller development of these arguments). The shift in less than a decade from foreign currency debt to local currency debt in the emerging markets, especially in Latin America, has been impressive (Table 1). Likewise there has been an impressive lengthening in the duration of government debt (Table 2), although there was some reversal in 2009.
Because currency mismatches had been reduced, most Latin American and Asian economies did indeed prove to be resilient during the crisis. This was true even when faced with very steep drops in the exchange rate. For many countries – Brazil is an excellent example – currency depreciation now improves the country’s net worth. Because of this, policy-makers can be more relaxed about currency depreciations – and can use monetary policy to stabilise their economies when faced with a decline in world demand. And many countries did so in the aftermath of this crisis.
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