CGFS report on financial stability and local currency bond markets

The Committee on the Global Financial System (CGFS)¹ is today releasing a report entitled Financial stability and local currency bond markets. It was prepared by a working group chaired by David Margolín, General Director of Central Bank Operations Bank of Mexico.

In releasing the report, Mr Margolín pointed out that the rapid development of local currency bond markets over the past five years or so had strengthened the financial systems of many emerging market economies (EME). Currency mismatches, the cause of so many earlier crises, have been eliminated or substantially reduced. Foreign financial institutions are channelling increasing volumes of funds into these markets. Many countries have therefore overcome "original sin" – the supposed inability to borrow in local currency. They have done this by adopting better macroeconomic policies, more prudent debt management strategies and significant financial sector reform.

Mr Margolín noted that the Working Group nevertheless identified certain features of EME bond markets, which reflect the comparative immaturity of these markets. These characteristics could create significant financial system risks. He drew attention to four key points:

1. Many markets are still comparatively illiquid, and most markets lack an adequate infrastructure for the derivative instruments that are necessary to manage market risk exposures.
    
2. A comparatively large proportion of bonds outstanding is held by banks. This means that market and credit risks still tend to be concentrated in banks, rather than being dispersed through capital markets.
    
3. Direct non resident ownership of local bonds appears to be very small. In reality, however, effective non resident exposure is much greater, but is achieved through derivative instruments (often offshore). Foreign investors are becoming increasingly interested in local currency bonds. Trading by foreign investors is rising sharply and having an increasingly important impact on pricing in these markets.
    
4. The public sector accounts for about 3/4 of bond issuance in developing countries, compared with only 1/3 in developed markets. There is, therefore, considerable room for corporate bond issuance and securitisation to develop further.

During recent, and rather modest, bouts of turbulence in international capital markets, these new markets have generally proved to be resilient. But conditions in most financial markets have been unusually benign. At some point, Mr Margolín warned, more volatile circumstances could well subject these markets to a stiffer test. Deepening and strengthening local currency bond markets to cope with this requires sustained policy efforts.

Chapter I Conclusion, pp 89-94, provides a summary of the report.

Specific questions regarding the report may be sent to the Committee on the Global Financial System by e-mail (CGFS@bis.org) or fax (+41 61 280 9100). For further information or to request a printed copy, please e-mail publications@bis.org.

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¹ The CGFS was established by the Governors of the G10 central banks to monitor and examine broad issues relating to financial markets and systems with a view to ensuring monetary and financial stability. The Committee is chaired by Donald L Kohn, Vice Chairman of the Board of Governors of the Federal Reserve System.