In 2022, accelerated monetary tightening in the United States led to currency depreciation and capital outflows in emerging markets. This situation underscores the vulnerability of these markets to global shocks.  

 Market liquidity suffers when investors sell risky assets and move their funds to safer, more liquid assets. This behavior is called "flight-to-quality" and "flight-to-liquidity." A shortage of liquidity, coupled with structural problems in the local market, might trigger a systemic financial crisis.

For instance, during the late 1990s, borrowers from developing Asian economies had maturity and currency mismatches in their balance sheets. These structural issues were significant factors behind the 1997/98 Asian Financial Crisis. Researchers have argued that emerging markets are vulnerable to shocks because they have difficulty borrowing from foreign sources in their domestic currency or securing long-term financing.

To address these weaknesses, many Asian economies have been working on developing local currency bond markets. The goal is to provide local currency funding, especially for longer terms, to borrowers. 

After more than 20 years of development, emerging East Asia has made significant progress in channeling long-term funding into its local currency bond markets. Size of local currency bond market increased from $866 billion in 2000 to $23.2 trillion by end of 2022, with foreign currency bonds’ share in total bond market declining. And during the same period, on average, 61.8% of the LCY bond issuance in the region carries a tenor of more than 5 years.       
 

The International Monetary Fund, in 2016, also stated that local currency bond market development can counter excessive cross-border capital flows. It can also decrease over-reliance on foreign capital and tackle the currency mismatch issue on balance sheets. 

Research has shown that local currency bond market development enhances financial stability. It achieves this by boosting borrowing in local currencies, offering diverse funding maturities, and enhancing risk management in the banking sector.

Our research found that  local currency bond market development bolsters currency stability during global market upheavals. A more extensive local currency bond market was linked with reduced exchange rate fluctuations during recent financial crises, including the pandemic and United States monetary policy tightening.

A higher proportion of local currency bonds in the total bond market and a greater share of long-term bonds generally correlate with reduced exchange rate fluctuations. This is a clear indication that local currency bond markets stabilize domestic currency during turbulent times. 

Local currency bond markets provide these benefits by providing local currency funding and longer-term borrowings, which act as buffers against liquidity shortages when foreign investors opt for safer assets. 

A local currency bond market is just one element that enhances financial stability. Robust economic fundamentals, such as adequate reserves, a healthy current account performance, a sound fiscal balance, and moderate inflation and domestic interest rates, are also crucial. 

 Emerging markets should keep diversifying their bond market investor base. This caters to varying bond maturities and risk appetites. It's also essential to improve transparency and institutional quality in financial markets, making them more appealing to global investors. Enhanced liquidity and improved hedging tools are vital to attract a diverse investor base. 

Local currency bond markets not only provide funds for various investment needs for developing countries, but they can also play a critical role in stabilizing currencies and economies in times of crises. 

This blog post was based on research for the publication, Emerging East Asian Local Currency Bond Markets: A Regional Update.