By Michael Pomerleano
As fears of debt disaster swirl around Dubai and Europe, it is useful to take a closer look at local currency bond markets. A recent superb book – This Time is Different: Eight Centuries of Financial Folly, by Carmen M. Reinhart and Kenneth Rogoff - offers a veritable tour de force of local currency markets. Reinhart and Rogoff have done an extraordinary job of putting together statistics covering eight centuries of government debt defaults around the world. The lengthy historical perspective documents never-ending cycles of boom and bust.
Their story is vastly different from the reports propagated by the official community. The official story of local currency bond markets reads roughly as follows. The typical report from a multilateral financial institution (and there have been several) points to the rapid development of local currency bond markets over the past years as a source of strength for financial systems in emerging-market economies. They report that foreign investment is buoyant, with foreign investors channeling increasing volumes of funds into these markets. The authors invariably commend developing countries for borrowing in local currency to reduce foreign currency mismatches end encourage them to adopt better macroeconomic policies, improve debt management strategies, and undertake further financial sector reform.
Typical reports note tactfully that the comparative immaturity of these markets leads to certain “features” (in order not to use the word vulnerability) that could create financial system risks. While noting some of the risks, they invariably conclude by encouraging sustained policy efforts to deepen and strengthen local currency bond markets.
Let me mention some of the problems not cited in the official reports of local currency bond markets.
First, local currency bond markets discourage fiscal discipline. Official reports typically have in mind public policy measures that are the product of sound decision-making in well defined, rational situations. The reality is vastly different. Politicians are driven largely by short-term considerations (the next poll and election; favoured constituents), which lead to myopic policy determinism.
In the absence of market discipline (vocal credit-rating agencies, risks of capital flows reversals), domestic local currency bond markets enable governments to accumulate unsustainable fiscal deficits. As indicated by the recent surge in public sector issuance, fiscally vulnerable countries defer confronting mounting deficits by allowing the debt burden to swell.
Several developing countries hover in the risky range of 80 per cent debt to gross domestic product, from which it is easy to tip to financial abyss. The rocky fiscal path eventually leads to ratings downgrades, more market sell-offs, and ultimately defaults. It is not surprising, therefore, that the public sector accounts for about 75 per cent of bond issuance in developing countries, compared with only a third in developed markets. As fiscal deficits continue to mount, the share of the public sector in bond issuance is on the rise. Failure to account for this reality makes favorable reports on the growth of domestic local currency bond markets dubious at best.
Second, the reports fail to recognize that local currency bond markets were not built in a deliberate virtuous cycle in order to mobilise resources to invest in the future, such as for infrastructure. Many markets grew by default in response to crises or other poor economic policies. For instance, in Indonesia and Korea, the market grew following the recapitalisation of banks in the rubble of financial crisis in the late 1990s. More recently, China’s local currency market accounts for more than 85 per cent of the growth in local currency bond markets. However, the Chinese bond market is not growing deliberately or endogenously. It is largely a short-term illiquid market attributable to placing sterilisation bonds in Chinese banks to contain the appreciation of the yuan.
Third, liquidity in most markets is non-existent. Most markets are “buy and hold” and illiquid, because a comparatively large proportion of government bonds outstanding are held by banks as part of prescribed reserve requirements. This implies that domestic and foreign investors have difficulty leaving those markets.
Fourth and interrelated, market and credit risks continue to be concentrated largely in banks, rather than being dispersed throughout capital markets, as witnessed during the recent global financial crisis.
Fifth, a flow of funds analysis of the net cash flows generated for long-term investment, such as for infrastructure, reveals that local currency bond markets are generating minute, if any, new resources. Very few markets have demonstrated capacity to generate resources for private sector development. Out of more than 100 developing countries in the world, the success is limited to Malaysia and Korea.
Sixth, outright foreign ownership of local bonds appears limited, and risks are not diversified away from the domestic system. Due to lack of liquidity, foreign investors take “carry trade” positions in domestic markets through offshore derivative instruments, such as non-deliverable forwards. The “investments” do not add net resources mobilised for domestic use but by forging stronger price integration with the global financial markets they compound volatility and sensitivity to global financial conditions. In this sense the investments undermine domestic monetary policy objectives. This conclusion echoes Dani Rodrik’s findings on the globalisation of finance.
Seventh, the political economic reality is that local currency corporate bond markets require credible supervision in the form of “multiple eyes” – effective regulators, disinterested and independent credit-rating agencies, disciplinarian institutional investors – that are often lacking. In the isolated instances where domestic corporate bond markets took off without an adequate infrastructure (such as in Israel), the performance was dismal for investors.
In conclusion, the official pronouncements that “this time is different” are premature when it comes to local currency bond markets. History will repeat itself.
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Michael Pomerleano has worked at the Bank of International Settlements and at the Bank of Israel
