The struggles of the Argentine peso and Turkish lira late last year reminded us once again of the vulnerability of emerging markets to external shocks such as rising US interest rates. That some Asian currencies—notably the Indian rupee and Indonesian rupiah—were also shaken despite their strong fundamentals gave further pause for thought.
Our recent research paper found that local currency bond markets mitigate the effects of external shocks on financial stability. This is particularly welcome news for Asia, where these markets have grown rapidly since the 1997-1998 Asian financial crisis, which clearly underlined the risk that currency and maturity mismatches pose to the financial stability of developing economies.
If a country’s financial liabilities are denominated in a foreign currency such as the US dollar, but its financial assets are denominated in the domestic currency, then a sudden depreciation of the local currency damages the national balance sheet, destabilizing the financial system and economy. And if the maturity of financial liabilities is shorter than that of assets, financial and economic instability are more likely.
Borrowing short-term in a foreign currency and lending long-term in a domestic currency—as Asia was prior to 1997—is a recipe for instability and even crisis.
It is generally accepted that local bond markets foster financial stability by providing a stable and local source for finance for longer terms compared to bank loans, while protecting domestic borrowers from exchange rate risk. In developing economies, vibrant local currency bond markets offering a variety of maturities can help channel savings into productive local investments such as infrastructure or housing, enabling better risk sharing and encouraging entrepreneurship and, ultimately, spurring economic growth.
Having local investment alternatives lightens the persistently high demand for US dollar-denominated assets that can contribute to global imbalances. Keeping that in mind, East and Southeast Asian countries have worked hard to develop their local bond markets since the 1997-1998 crisis.
We decided to check the largely untested conventional wisdom that more developed local currency bond markets promote financial stability by mitigating currency and maturity mismatches.
To do so, we analyzed and compared the effect of local currency bond markets on financial vulnerability in developing countries within and outside Asia during two episodes of financial stress. These are the global financial crisis of 2007-2008 and the so-called “taper tantrum” of 2013, when the US Federal Reserve started to reduce its injections of funds into the economy.
We measured financial vulnerability through depreciation of the local currency against the US dollar on the basis that more vulnerable countries suffer sharper declines in their currencies. For example, during the emerging market foreign exchange turmoil of 2018, countries with weak fundamentals—for example, high inflation and sizable current account deficits—such as Argentina and Turkey experienced sharp exchange rate depreciation.
Of course, many other factors besides local bond markets can influence the depreciation of emerging market currencies during financial stress: exchange rate regime, inflation, economic growth, current account deficit, and capital inflows. Our econometric analysis incorporated and controlled for all such factors.
We found was that countries which had experienced a larger expansion of their local currency bond markets also saw a smaller depreciation of their exchange rates, indicating that local currency bond markets can indeed promote financial stability in developing countries. At a broader level, the analysis lends some support to the popular but largely untested view that development of local bond markets is an integral part of Asia’s quest for a balanced, strong, and resilient financial system.
Note on chart: ASEAN+3 total is the sum of the USD values of the LCY bonds outstanding in the People's Republic of China; Hong Kong, China; Indonesia; Republic of Korea; Malaysia; Philippines; Singapore; Thailand, and Viet Nam.