BIS Working Papers No 391 Emerging market local currency bonds: diversification and stability by Ken Miyajima, M S Mohanty and Tracy Chan Monetary and Economic Department November 2012 JEL classification: E43, F36, G12. Keywords: Currency mismatches, emerging market local currency bond, diversification benefit, safe asset, panel VAR BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2012. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) iii Emerging market local currency bonds: diversification and stability Ken Miyajima, M S Mohanty and Tracy Chan 1 Abstract Over the past three years, cross-border inflows into emerging market (EM) local currency bonds have surged. The returns on these bonds have moved more closely with those on international assets regarded as “safe”, particularly following the euro area debt crisis. This paper first demonstrates that domestic factors have tended to dictate the dynamics of the EM local currency government yield. The importance of local drivers has probably increased the potential diversification benefit, creating strong appetite for the asset class. Second, the paper confirms that EM local currency government yields have behaved more like safe haven yields since 2008: they have dropped, rather than increased, in response to worsening global risk sentiment. Yet EM local currency government yields could be susceptible to adverse external shocks: the yield dynamics have been affected by unsustainably low US Treasury yields. Moreover, the international role of EM local currency bonds depends crucially on the behaviour of exchange rates. Nevertheless, the further development of local currency bond markets should help strengthen the stability of the international monetary and financial system. JEL classification: E43, F36, G12. Keywords: Currency mismatches, emerging market local currency bond, diversification benefit, safe asset, panel VAR 1 Miyajima is Senior Economist at the Bank for International Settlements (BIS); Mohanty is Head of Emerging Markets of the Monetary and Economic Department at the BIS; Chan is Research Analyst at the BIS. We thank Bernd Braasch, Gerard Caprio, Torsten Ehlers, Enisse Kharroubi, Előd Takáts, Philip Turner, Christian Upper, Fabrizio Zampolli and the participants at the Third International Workshop on Developing Local Currency Bond Markets in Emerging Market Economies and Developing Countries held at the Deutsche Bundesbank in November 2011 for comments. The views expressed in this paper are the authors’ own and not necessarily those of the BIS. iv Contents 1. Introduction 1 2. Emerging market local currency bonds as an asset class? 3 2.1 EM bond markets during the recent crisis 3 2.2 Diversification benefits from EM local currency government bonds 4 2.2.1 Is the performance determined by global or domestic factors? 5 2.2.2 The role of the exchange rate 6 3. Results from yield models 7 3.1 The model 7 3.2 Econometric methodology and data 8 3.3 Benchmark model 9 3.4 Expanded benchmark model 12 3.4.1 Capital account openness (annual model) 13 3.4.2 Currency mismatches (annual model) 13 3.4.3 Central bank financing needs (monthly model) 14 3.5 Additional robustness checks 14 3.5.1 Tests on endogeneity 15 3.5.2 Using realised values 15 4. Testing for resilience 17 4.1 A dynamic panel model 17 5. Conclusion and policy implications 19 Annex Tables 21 1 1. Introduction Historically, increased risk aversion in global financial markets has reduced capital flows into emerging market (EM) debt products. Yet, cross-border inflows into EM local currency bonds have surged over the past three years. The growing interest of foreign investors in EM debt could partly reflect the much discussed shortage of global safe assets 2 (Caballero, Farhi and Gourinchas, 2008; and Gourinchas and Jeanne, 2012). In particular, since the beginning of the euro area debt crisis in 2010, the returns on EM local currency government bonds have moved closely with those on safe haven assets. At the same time, the recent surge has been accompanied by very low global interest rates and exceptional monetary easing by advanced economies that will almost certainly end at some point. In this paper, we examine the factors behind the observed resilience of EM local currency government bonds. Does their recent performance represent a fundamental change in the characteristics of these assets? Do EM local currency bonds provide enough diversification benefits to be considered as a distinct and, possibly, safer asset class? Or, will the recent surge end in a crash, as has happened in previous episodes of crises in emerging market economies (EMEs) that followed monetary tightening in advanced economies? The appeal of an asset depends on at least two crucial factors. First, from the point of view of portfolio diversification, the asset is more attractive when the return is determined by a set of idiosyncratic factors and less correlated with other asset returns. Second, the asset is more attractive when the volatility of returns is low, thereby allowing investors to anticipate the asset’s future returns with a lower degree of uncertainty. This suggests that, to be attractive as an investment proposition, not only should returns on EM bonds be determined more by domestic factors than global ones, but they must also be resilient to various shocks. 3 Views about an international role for EM local currency bonds have varied widely. Some years ago, Eichengreen and Hausmann (1999) advanced the “original sin” hypothesis, which argues that EMEs lack the capacity to borrow in their own currencies, because international transactions are mostly denominated in currencies of a few advanced economies. Over the past decade, however, better macroeconomic policies and low inflation have made local currency paper more attractive in many EMEs for international investors. The EMEs’ capacity to develop domestic bond markets has been clearly demonstrated. This has reflected changes in their domestic institutions, macroeconomic and monetary policies, market infrastructure and global financial integration (Classens et al, 2007; Gagnon, forthcoming; Goldstein and Turner, 2004; Montoro and Rojas-Suarez, 2012; and BIS, 2002; 2012a; 2012b). And this development has coincided with strong growth and better fiscal prospects in EMEs. There has been a steady increase in the foreign ownership of EM local currency bonds in the past decade. 4 In addition, the local currency bonds of a number of EMEs are now included in the global bond indices. 5 Echoing a positive view, the Committee 2 Following Gourinchas and Jeanne (2012), an asset is considered as “safe” when risks associated with credit, market, inflation and exchange rate are low. 3 Yet, domestic factors are likely to be correlated with global factors to some extent, particularly in times of a large global common shock. 4 For instance, at the beginning of the 2000s foreign investors accounted for less than 1% of the total stock of local currency sovereign bonds in most EMEs (the exception was Hungary where this share was 47%). However, by 2010 this share had risen to 30% in Indonesia, 18–22% in Mexico and Malaysia, 14% in Brazil and 10% in Korea. 5 Domestic government bonds issued in five EMEs are currently included in the widely used Citigroup World Government Bond Index (WGBI), which consists of government bonds issued by 23 countries. These are Malaysia (included in 2007), Mexico (2010), Poland (2003), Singapore (2005), and South Africa (2012). The 2 on the Global Financial System (2007) argued that “…because local currency bonds represent attractive yield enhancement and diversification vehicles for foreign investors, further substantial growth seems likely in years ahead even if some cyclical reversal may occur”. An important question is: what determines the diversification benefit from investing in EM assets. Some have argued that diversification benefits from assets denominated in local currencies depend crucially on the behaviour of the exchange rate (Burger and Warnock, 2007; and Turner, 2012). Others stress relative volatility. Because EM currencies tend to be more volatile than those of advanced economies, any diversification benefits from EM assets are likely to be small. In examining the potential diversification role of EM local currency bond markets, we proceed in two stages. First, following Caporale and Williams (2002) and Gonzalez-Rozada and Yeyati (2008), we present a basic model to disentangle the effects of domestic and external factors on local currency government bond yields in EMEs, and then estimate it in a static panel framework. In the second stage, we use a dynamic panel VAR model to test whether these yields were resilient to shocks during the second half of the 2000s. These EM yields are modelled in local currency terms, assuming that expected exchange rate changes are reflected in interest rates. The model also considers determinants of exchange rates to capture the impact of exchange rates on EM domestic yields. Compared to the way the literature sometimes uses capital flows as a proxy for EM asset performance, bond yields provide indirect evidence on how far EM bond markets have come up as an alternative asset class to compete with some of the advanced economy bond markets. It is also worth highlighting that our approach to some extent builds on the premise that EM domestic bond markets have matured, whereas the literature has focused on the capacity of EMEs to build domestic bond markets. 6 Our results suggest that domestic factors – particularly monetary and fiscal policy – played a relatively more important role than global factors such as US bond yields and the VIX (which is the implied volatility of the S&P 500 stock index) in dictating local currency bond yields in EMEs over the past decade. And, these bond yields were quite resilient to both domestic and global shocks. These findings are robust to alternative specifications, different estimation periods and various endogeneity tests conducted in the paper. That said, US Treasury yields have been an important – if not dominant – determinant of EM local currency bond yields particularly during the recent global monetary easing cycle. This implies that the recent good performance of some EM bond markets is probably not sustainable. These findings have implications not only for the potential for EM local currency bonds to become a safe asset class but also for the exposure of EMEs to future financial shocks. The rest of the paper is structured as follows. Section II discusses basic facts and findings in other studies about EM bonds as an asset class. Section III presents the theoretical model as well as the empirical results from a static panel framework. Using the Choleski decomposition strategy, Section IV examines the capacity of EM local currency government bonds to withstand shocks. The final section explores a few policy implications of the main findings. market weights for most of the EMEs are in the range of 0.4–0.6%, comparable to those of Finland or Ireland, but much smaller than those of Japan or the US. 6 See, for instance, Eichengreen and Luengnaruemitchai (2006), Classens, Klingebiel and Schmukler (2007), and Mehl and Reynaud (2005). 3 Graph 1 Cumulative net inflows to mutual funds dedicated to emerging market bonds In USD bn Source: EPFR. 2. Emerging market local currency bonds as an asset class? Global bond markets have seen large changes since the onset of the global financial crisis in 2008. As IMF (2011) notes, two, rather opposing, forces have influenced asset allocation by institutional investors. On the one hand, burned by large losses, these investors have become more sensitive to credit and liquidity risks than they were before the crisis. On the other hand, cyclical factors such as very low global interest rates may have tempted them to take on additional risks by going beyond their traditional asset classes. In this environment, EMEs that enjoy strong growth and balance sheet positions are seen as providing attractive investment opportunities to investors. 2.1 EM bond markets during the recent crisis Recent changes in investor behaviour have been accompanied by at least two major developments in EM bond markets. First, as Graph 1 shows, cross-border inflows into EM bond markets have risen rapidly since 2009. Prior to 2008, the cumulative inflows into mutual funds dedicated to EM bonds reached about $30 billion. Although the inflows collapsed following the 2008 Lehman crisis, they rebounded towards the end of 2009. In the following two and half years, these inflows rose at a dramatic rate, reaching some $120 billion by July 2012. What is interesting to note is that a relatively large part of such inflows has been directed to bonds denominated in local currencies. Investor interest is growing in all types of EM bonds, irrespective of currency denomination. However, the share of local currency-denominated bonds in the total has risen from virtually zero in mid-2005 to almost half by the middle of 2012. Given the relatively small size of the EM corporate debt markets, a large share of the inflows has likely been directed to securities issued either by governments or central banks. A second related development concerns the performance of these assets. Graph 2 shows total returns (interest income and capital gains) from EM local currency government bonds, as represented by the JP Morgan local currency government bond index, and those from US Treasury bonds. It also shows the VIX, a measure of global risk aversion. During 2003–07, a period of low global risk aversion, EM bonds fetched annual average returns of about 9%, significantly greater than the returns on US Treasuries of about 4%. Investors demanded a positive – and often substantial – premium for investing in EM local currency government bonds. 4 Graph 2 Annual returns on US Treasury and EM domestic government bonds and VIX In per cent 1 US Treasury total return index USD. 2 GBI-EM broad traded total return index local currency. Sources: Bloomberg; JPMorgan Chase; BIS staff calculations. The performance of EM bonds deteriorated as risk sentiment worsened in the run-up to the 2008 crisis, but rebounded as early as the end of 2008. During the most recent period of high risk aversion related to the euro area debt crisis, returns on EM local currency government bonds almost converged with those on US Treasuries. The returns on these two assets have again diverged since the beginning of 2012, after the US Treasury returns dropped sharply, partly as tentative hopes that major central banks may act to help boost economic growth prompted investors to rotate out of US Treasury bonds. The strong performance of the EM local currency government bonds also stands out when we look at their risk-adjusted returns, as measured by the ratio of median annual returns to volatility of returns (known as the Sharpe ratio). Graph 3 shows the Sharpe ratios for a range of assets during periods of high (2008–12) and low global risk aversion (2002–07). The y- axis shows the median returns and the x-axis standard deviation of returns; the size of the bubble represents the magnitude of the Sharpe ratio. The returns on all EM local currency assets are unadjusted for exchange rate changes, so that currency risks are assumed to be hedged by investors. Compared with other asset classes, EM local currency government bonds have had one of the best Sharpe ratios in both good and bad times. During 2002–07, the Sharpe ratio of EM local currency government bonds was the highest (0.9), as their low returns were offset by the stability of the returns, followed by EM foreign currency government bonds in dollars and EM equities (all 0.5). It is interesting to note that, during 2008–12, when investors’ risk sentiment was weak, the Sharpe ratio of EM local currency government bonds (0.3) still continued to be the highest. Moreover, the dispersion of Sharpe ratios across asset classes rose, while those of oil and EM equities fell into negative territory. 2.2 Diversification benefits from EM local currency government bonds The recent performance of EM local currency government bonds raises the question as to whether they can be an alternative to some of today’s advanced market bonds. 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BIS Working Papers No 391 Emerging market local currency bonds: diversification and stability by. panel VAR BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International