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Global Financial Stability Notes No. 2021/04
Drivers of Emerging Market Bond Flows and Prices
Written by: Rohit Goel and Evan Papageorgiou
December 2021
DISCLAIMER: The views expressed are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
An interesting disconnect has taken shape between local currency- and hard currency-denominated bonds in emerging markets with respect to their portfolio flows and prices since the start of the recovery from the COVID-19 pandemic. Emerging market assets have recovered sharply from the COVID-19 sell-off in 2020, but the post-pandemic recovery in 2021 has been highly uneven. This note seeks to answer why. Yields of local currency-denominated bonds have risen faster and are approaching their pandemic highs, while hard currency bond yields are still near their post-pandemic lows. Portfolio flows to local currency debt have similarly lagged flows to hard currency bonds. This disconnect is closely linked to the external environment and fiscal and inflationary pressures. Its evolution remains a key consideration for policymakers and investors, since local markets are the main source of funding for emerging markets. This note draws from the methodology developed in earlier Global Financial Stability Reports on fundamentals-based asset valuation models for funding costs and forecasting models for capital flows (using the at-risk framework). The results are consistent across models, indicating that local currency assets are significantly more sensitive to domestic fundamentals while hard currency assets are dependent on the external risk sentiment to a greater extent. This suggests that the post-pandemic, stressed domestic fundamentals have weighed on local currency bonds, partially offsetting the boost from supportive global risk sentiment. The analysis also highlights the risks emerging markets face from an asynchronous recovery and weak domestic fundamentals1
Emerging markets were affected by the pandemic the most and they continue to be. Excluding China, growth in emerging markets is expected at 6.8 percent in 2021 (as opposed to 7.2 percent in advanced economies), and a two-speed global recovery has taken shape, with emerging markets at a lower gear (October 2021 World Economic Outlook). The slower recovery in emerging markets has important implications for capital markets as well, and an interesting disconnect has appeared. This Global Financial Stability Note draws on findings and on several econometric models for the valuation of emerging market bonds and the drivers of portfolio flows derived in earlier Global Financial Stability Reports (IMF 2018b, 2019b, 2020a) to answer some pertinent questions regarding the drivers of these developments. The policy implications are the same as those expressed in those reports and are not repeated here. Instead, this note aims to collect the findings and methodologies for a more complete discussion.
Section 1 of this note discusses the disconnect between hard currency and local currency bonds and portfolio flows and highlights ancillary findings. Section 2 discusses the asset valuation models for local currency and hard currency bond funding costs and Section 3 presents two models for emerging market capital flows: one using the IMF’s at-risk methodology using a quarter-century of data (IMF 2018a and 2020b), and one that zeroes in the post COVID-19 recovery period, using a simple ordinary least squares (OLS) regression specification.
