## Chapter 3 at a Glance ## Source details **Canonical URL:** [Chapter 3 at a Glance](https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/ch3.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2020/april/english/ch3.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2020/april/english/ch3.pdf.json) --- ### Main findings on portfolio flows and vulnerabilities - The COVID-19 pandemic led to an unprecedented sharp reversal of portfolio flows, highlighting challenges of managing such volatility in emerging and frontier markets. - Changes in global financial conditions tend to influence portfolio flows more during surges and reversals than in normal times. - Stronger domestic fundamentals do not always lead to surges in portfolio flows but do help mitigate outflows. - Greater foreign investor participation in local currency bond markets can help reduce borrowing costs but may increase price volatility where domestic markets lack depth, especially in frontier markets. - Strong and persistent portfolio inflows in earlier periods can create vulnerabilities by encouraging excessive domestic credit creation and an overvaluation of local currency and other financial assets; these risks need to be managed. ### Trends and key statistics - Foreign participation in local currency debt markets grew from 10 percent of the total in 2000 to almost 25 percent recently. - Total debt for the median emerging market economy rose to 100 percent of GDP in 2018 from 75 percent before the global financial crisis. - Total debt in China rose to more than 250 percent of GDP in 2018 from 140 percent in 2007. - Nonresident bond portfolio flows dominate equity flows in aggregate. - Since 2013, portfolio inflow episodes have been shorter, while outflow episodes have lasted longer. - Many emerging market sovereigns have stepped up issuance of local currency debt in recent years. ### Risks from increased foreign participation and debt - Increased foreign participation in debt markets exposes countries to changes in global financial conditions through foreign investor behavior and preferences. - During periods of risk aversion, foreign investors are likely to reduce exposure and might not roll over maturing positions, triggering outflows that could disrupt bond markets. - Foreign currency hedging associated with foreign participation can exert pressure on exchange rates and funding costs. - A rise in foreign investor participation in the local currency bond market beyond a certain critical threshold—controlling for the domestic investor base—can significantly increase yield volatility; some frontier markets already exceed that threshold. - Greater depth of domestic financial markets and a larger local investor base can help reduce local currency bond price volatility. - The high secondary market bond price volatility during Q1 2020 under the COVID-19 shock underscores the need to balance attracting foreign investors and developing domestic financial markets, including improving liquidity of foreign currency markets and availability of hedging instruments. ### Analytical approach and drivers of flows - Uses the capital-flows-at-risk methodology to study impact of global and domestic factors on distributions of near-term (current quarter and next two quarters) portfolio flows to emerging markets. - Focus on total debt and equity flows and on hard currency versus local currency debt flows. - Global (“push”) factors used in regressions include: - Chicago Board Options Exchange Volatility Index (VIX) - US Dollar Index (DXY) - US 10-year Treasury yield - Domestic (“pull”) factors used in regressions include: - Domestic GDP growth - Ratio of short-term foreign exchange debt to international reserves - Depth of domestic financial markets - GDP per capita - Capital account openness - Regressions include country fixed effects and period dummies (prior to, during, and following the global financial crisis); analysis focuses on predicted distributions (quantile regressions) to quantify likelihoods of surges or reversals. ### Empirical insights on sensitivities and heterogeneity - Debt flows tend to be influenced more by global (common) factors than by country-specific (idiosyncratic) factors; equity flows are more heavily influenced by domestic factors, such as growth. - For both bond and equity flows, changes in global financial conditions tend to affect the tails of predicted portfolio flow distributions (likelihood of future surges or reversals) more than the median. - The outlook for local currency bond flows has greater sensitivity to domestic vulnerabilities than the outlook for hard currency bond flows. - Strong growth prospects can limit the likelihood of future outflows from local currency bond markets but can also amplify the likelihood of future surges. - Domestic bond yields are highly sensitive to external factors, especially for low-rated economies. ### Policy-relevant implications - Use distributional (capital-flows-at-risk) analysis to quantify likelihoods of extreme inflow or outflow outcomes and help policymakers prepare for future reversals or surges of portfolio flows. - Balance the benefits of attracting foreign investors (lower funding costs) with the risks of increased rollover risk and price volatility, particularly in frontier market economies. - Strengthen domestic financial market depth and expand the local investor base to mitigate yield and price volatility from higher foreign participation. - Improve liquidity in foreign currency markets and expand availability of hedging instruments to reduce exchange rate and funding cost pressures during episodes of risk aversion. --- ### Debt versus Equity Portfolio Flows ### Global factors and debt flows - Easier global financial conditions shift the entire distribution of predicted debt flows to the right. - Lower volatility (VIX), lower US Treasury yields, and a weaker US dollar increase near-term debt inflows. - A 1 point increase in the FCI increases the average size of flows in the lower tail of the predicted distribution by 0.06 percent of GDP and in the upper tail by 0.09 percent of GDP. - Lower US Treasury bond yields and a weaker US dollar increase the likelihood of strong debt inflows considerably more than they decrease the likelihood of negative or weak flows. - Risk aversion (VIX) affects strong and weak debt flows in roughly equal magnitudes. - The strengthening of the US dollar and higher market volatility alone weaken the median predicted quarterly flows by 1 percent of GDP for an average emerging market economy. - During the last quarter of 2008, the US Dollar Index and the VIX increased by about 10.5 points and 33.5 points, respectively. As of mid-March 2020, the US Dollar Index and the VIX were 10.5 points and 43 points higher, respectively, than at the end of 2019. ### Domestic fundamentals and equity contrasts - Stronger domestic growth reduces the likelihood of negative or weak debt inflows but does not by itself increase the likelihood of very large inflows. - Greater external vulnerabilities (higher short-term foreign currency debt relative to international reserves) are linked to a larger likelihood of negative or weak debt inflows; when short-term debt is higher today, the likelihood of very strong inflows increases too, but to a lesser extent. - Deeper domestic financial markets improve the outlook for debt flows across the board. - Equity flows are less sensitive to global factors than debt flows. - A stronger US dollar weakens the near-term outlook for equity flows across the board, but its impact is an order of magnitude smaller than for debt flows. - Stronger domestic growth contributes more to an increased likelihood of strong equity inflows than to strong debt inflows. - Deeper domestic financial markets do not reduce the likelihood of negative or weak equity inflows in the same way they do for debt flows. --- ### Hard Currency versus Local Currency Debt Portfolio Flows ### Relative sensitivities and drivers - Better domestic fundamentals and economic prospects improve the outlook for both local and hard currency debt portfolio flows. - Local currency flows are more sensitive to domestic factors than hard currency flows. - Local currency debt flows are more sensitive to the level of external vulnerabilities than hard currency flows. - A 1 percentage point rise in the ratio of short-term debt to international reserves could lower the local currency debt flows at risk by 0.4 percent of GDP and hard currency debt flows at risk by 0.2 percent of GDP. - Higher growth boosts expected flows and affects the tails of the portfolio flow distribution twice as much. - The outlook for local currency flows is almost three times more sensitive to domestic growth than the outlook for hard currency flows. - Deeper domestic financial markets improve the outlook for both hard currency and local currency flows and significantly limit the likelihood of negative or weak flows. - The probability of significant bond outflows (equivalent to the 5th percentile of historical events) declines from about 35 percent to less than 10 percent when market depth increases by one standard deviation. - Tighter global financial conditions decrease expected portfolio flows and disproportionately affect the likelihood of extreme flows. - Hard currency flows are almost twice as sensitive as local currency flows to changes in global financial conditions. - Median foreign ownership of emerging market local currency bonds is just about 20 percent. --- ### Impact of Portfolio Flows on Funding Costs and Volatility ### Pricing influences and foreign participation - Sovereign debt pricing is linked to country-specific fundamentals and global investors’ risk appetite. - Strong domestic fundamentals help lower funding costs; tight global financial conditions can widen spreads. - Nonresident holdings can reduce borrowing costs, currency mismatches, and rollover risks associated with external borrowing; they diversify the investor base and can increase market size beyond domestic absorption capacity. - Foreign investor decisions can strengthen the link between exchange rate fluctuations and domestic financial conditions; reductions in foreign positions can create domestic debt rollover risks. - Local currency bond outflows can increase term premiums and long-term interest rates, affecting domestic activity. - Foreign holdings can transmit global financial shocks to local currency sovereign bond markets by increasing yield volatility and, beyond a threshold, amplifying spillovers from global shocks. ### Market depth and funding cost sensitivities - Depth helps mobilize savings, promote information sharing, diversify risk, buffer the economy against external shocks, and dampen asset price volatility. - Deepening has benefits but may also entail a “too much finance effect.” - Stronger domestic fundamentals are associated with lower funding costs. - High inflation increases local currency bond yields; better growth prospects contribute to lower yields. - Elevated vulnerabilities and lower buffers (higher external debt, lower foreign exchange reserves) are associated with higher local currency yields. - IMF staff analysis suggests sensitivity of local currency bond yields to the level of foreign exchange reserves has increased in recent years, while sensitivity to external debt appears to have declined somewhat. --- ### Sensitivity of Local Currency Yields to Reserves/GDP and External Debt/Exports ### Key empirical findings on yield sensitivity and investor base - Funding cost is lowered by stronger domestic fundamentals and higher foreign participation. - Local currency bond yields have become more sensitive to reserve adequacy and less sensitive to the level of external debt. - Scaling examples (as reported in the source panel): - For every 10 basis point increase in growth, yields change by –0.9 basis points. - For every 1 percentage point increase in external debt (to exports), yields change by 1 percentage point. - Credit-rating and global risk-sentiment effects: - A 100 basis point increase in US BBB-rated corporate spreads could widen yields of high-yield emerging market bonds by almost 100 basis points, compared with only 40 basis points for investment-grade issuers. - Hard-currency bond spreads, especially for high-yield issuers, are affected about 60 percent more by global risk aversion shocks than local-currency spreads. - Inflation and growth effects on spreads: - Every percentage point rise in inflation increases local currency bond spreads by more than 70 basis points, but increases hard currency bond spreads by only 20 basis points. - GDP growth has a greater impact on hard currency bond spreads than on local currency spreads. - Ratings convergence: - For 80 percent of the countries in the sample, there is currently no difference between the local and foreign currency rating, compared with 50 percent at the time of the global financial crisis and 20 percent during the Asian financial crisis. - The convergence has been driven by a worsening of local currency ratings. - Market composition: Local currency bonds now account for almost 90 percent of the marketable emerging market fixed-income universe compared with 75 percent in 2008. ### Volatility, thresholds, and magnitudes - Greater foreign participation in local currency bond markets increases the volatility of yields after it reaches a certain threshold; further domestic financial deepening helps reduce volatility. - When the size of foreign investor bond holdings exceeds about 40 percent of the country’s international reserves, the volatility of yields is found to increase by about 15 percent. - On average, domestic financial market deepening helped emerging market economies dampen volatility by 39 percent during 2004–17. ### Table 3.1 (estimates; sample details) - Sample: quarterly data from 18 emerging market economies during 2004–17; observations = 741. - Coefficients for the interaction of Financial Market Depth and Dummy: Foreign Participation at thresholds (Percent): - Threshold 37: Financial Market Depth –1.051*** ; Dummy: Foreign Participation 0.009 - Threshold 38: Financial Market Depth –1.029*** ; Dummy: Foreign Participation 0.060 - Threshold 39: Financial Market Depth –1.015*** ; Dummy: Foreign Participation 0.090 - Threshold 40: Financial Market Depth –0.980*** ; Dummy: Foreign Participation 0.147** - Threshold 41: Financial Market Depth –0.969*** ; Dummy: Foreign Participation 0.163** - Threshold 42: Financial Market Depth –0.967*** ; Dummy: Foreign Participation 0.205*** - Threshold 43: Financial Market Depth –0.980*** ; Dummy: Foreign Participation 0.188** - Significance levels: ***p < 0.01; **p < 0.05; *p < 0.1. --- ### Frontier Markets: Liquidity, Rollover Risks, and Development Priorities ### Frontier market vulnerabilities and empirical observations - Strong investor interest in frontier markets in 2017–19 increased nonresident exposures in FX and local currency bond markets; Egypt and Nigeria had large overweight exposures concentrated in high-yielding short-term debt segments. - During COVID-19 turbulence, economies with greater nonresident investor participation experienced larger yield increases and higher exchange rate volatility; some frontier markets saw 12-month nondeliverable forwards depreciate by more than 20 percent. - Frontier market structural features: shallower domestic investor base, lower financial depth, larger bid-offer spreads, and higher price impact of trades relative to emerging markets; many frontiers rank well below the emerging market median on financial market and institutions depth indices. - Development impacts (model-based): bringing a frontier market’s financial depth to the emerging market average could: - Lower the volatility of its local currency bond yield by almost 30 percent. - Improve the portfolio debt flow outlook by 1.2 percent of GDP, on average. - Reduce the probability of net nonresident outflows by 15 percentage points. ### Policy priorities and recommendations for frontier markets - Policy responses depend on the shock type (liquidity vs solvency), fiscal and monetary space, market depth, and balance-sheet vulnerabilities; interventions should be tailored across foreign exchange, capital flows, sovereign debt management, and macroprudential settings. - Foreign currency interventions: - For countries with flexible exchange rates, credible monetary frameworks, low inflation, deep financial markets, and absence of large currency mismatches: let the exchange rate be a key shock absorber. - For countries with adequate reserves: exchange rate intervention can lean against market illiquidity and mute excessive volatility, but should not prevent necessary adjustments; interventions should be based on expectation that pressures could last several months or longer. - For fixed or tightly managed regimes: if reserves are adequate, maintaining the regime may be best short-term; interventions may need support from monetary tightening and possibly capital flow management measures, with policies premised on outflow pressures lasting several months or longer. - Capital flow management measures: - In an imminent crisis, capital outflow management measures can be part of a broad package but cannot substitute for warranted macroeconomic adjustment. - If nonresident outflows drive overall outflows, consider minimum holding periods, caps, and other limits on nonresidents’ transfers abroad, implemented transparently, temporarily, and lifted once crisis conditions abate, with due regard to international obligations. - Sovereign debt management strategy: - Prepare for long-term external funding disruptions. - Countries with continued market access at reasonable rates should actively decrease rollover risks; lowering rollover risks should take priority over containing costs when downside risks to market access are large. - Consider interactions between government financing strategy and domestic private/state-owned issuers to avoid exacerbating risks. - Macroprudential policy: - If macroprudential buffers exist, relaxing these tools can reduce the shock’s impact on market conditions and the economy. - Examples: relax foreign currency reserve requirements to mitigate FX funding pressures; allow banks to use liquidity coverage ratio buffers in foreign currency or relax the requirement. ### Longer-term development priorities - Prioritize local capital market development and promotion of a stable, diversified local investor base, requiring coordination and sequencing of reforms. - Specific measures include: - Developing efficient money markets. - Strengthening primary market practices to enhance transparency and predictability of issuance. - Bolstering market liquidity. - Developing a robust market infrastructure. --- ### Policy Guidance on Managing Volatile Portfolio Flows ### Key recommendations and implementation considerations - Implement or tighten macroprudential tools preemptively during episodes of strong investor appetite to build resilience and limit systemic risk. - Assess the prudent level of foreign investor participation by explicitly accounting for local market capacity to absorb external shocks without excessive volatility. - Exercise caution when liberalizing portfolio inflows in early-stage local markets or when macroeconomic policy space is limited. - Favor gradual liberalization strategies for countries moving away from portfolio flow restrictions: - Transition toward quantitative limits; or - Use price-based restrictions such as taxes and reserve requirements to mitigate excessive inflows. - Strengthen the legal and regulatory framework governing securities markets to support stable foreign participation. - Preemptive application and, where appropriate, long-term or permanent maintenance of macroprudential measures can reduce the likelihood that sudden inflow surges lead to systemic financial stress. - The choice between quantitative limits and price-based restrictions should reflect domestic market structure, institutional capacity, and the objective of minimizing distortion while containing risks. - Policymakers need comprehensive evidence on market absorption capacity and potential spillovers before encouraging higher levels of foreign participation. - Gradual approaches to liberalization can provide flexibility to recalibrate measures if market development or macroeconomic conditions change. *International Monetary Fund | April 2020 — Chapter 3 at a Glance* ### Chapter 3 at a Glance ### Chapter 3 at a Glance ### Main findings on portfolio flows and vulnerabilities - The COVID-19 pandemic led to an unprecedented sharp reversal of portfolio flows, highlighting challenges of managing such volatility in emerging and frontier markets. - Changes in global financial conditions tend to influence portfolio flows more during surges and reversals than in normal times. - Stronger domestic fundamentals do not always lead to surges in portfolio flows but do help mitigate outflows. - Greater foreign investor participation in local currency bond markets can help reduce borrowing costs but may increase price volatility where domestic markets lack depth, especially in frontier markets. - Strong and persistent portfolio inflows in earlier periods can create vulnerabilities by encouraging excessive domestic credit creation and an overvaluation of local currency and other financial assets; these risks need to be managed. ### Trends and key statistics - Foreign participation in local currency debt markets grew from 10 percent of the total in 2000 to almost 25 percent recently. - Total debt for the median emerging market economy rose to 100 percent of GDP in 2018 from 75 percent before the global financial crisis. - Total debt in China rose to more than 250 percent of GDP in 2018 from 140 percent in 2007. - Nonresident bond portfolio flows dominate equity flows in aggregate. - Since 2013, portfolio inflow episodes have been shorter, while outflow episodes have lasted longer. - Many emerging market sovereigns have stepped up issuance of local currency debt in recent years. ### Risks from increased foreign participation and debt - Increased foreign participation in debt markets exposes countries to changes in global financial conditions through foreign investor behavior and preferences (illustrated by volatility around the COVID-19 pandemic). - During periods of risk aversion, foreign investors are likely to reduce exposure and might not roll over maturing positions, triggering outflows that could disrupt bond markets. - Foreign currency hedging associated with foreign participation can exert pressure on exchange rates and funding costs. - A rise in foreign investor participation in the local currency bond market beyond a certain critical threshold—controlling for the domestic investor base—can significantly increase yield volatility; some frontier markets already exceed that threshold. - Greater depth of domestic financial markets and a larger local investor base can help reduce local currency bond price volatility. - The high secondary market bond price volatility during Q1 2020 under the COVID-19 shock underscores the need to balance attracting foreign investors and developing domestic financial markets, including improving liquidity of foreign currency markets and availability of hedging instruments. ### Analytical approach and drivers of flows - The chapter uses the capital-flows-at-risk methodology to study the impact of global and domestic factors on distributions of near-term (current quarter and next two quarters) portfolio flows to emerging markets, focusing on total debt and equity flows and on hard currency versus local currency debt flows. - Global (“push”) factors used in regressions include: - Chicago Board Options Exchange Volatility Index (VIX) - US Dollar Index (DXY) - US 10-year Treasury yield - Domestic (“pull”) factors used in regressions include: - Domestic GDP growth - Ratio of short-term foreign exchange debt to international reserves - Depth of domestic financial markets - GDP per capita - Capital account openness - Regressions include country fixed effects and period dummies (prior to, during, and following the global financial crisis); analysis focuses on predicted distributions (quantile regressions) to quantify likelihoods of surges or reversals. ### Empirical insights on sensitivities and heterogeneity - Debt flows tend to be influenced more by global (common) factors than by country-specific (idiosyncratic) factors; equity flows are more heavily influenced by domestic factors, such as growth. - For both bond and equity flows, changes in global financial conditions tend to affect the tails of predicted portfolio flow distributions (likelihood of future surges or reversals) more than the median. - The outlook for local currency bond flows has greater sensitivity to domestic vulnerabilities than the outlook for hard currency bond flows. - Strong growth prospects can limit the likelihood of future outflows from local currency bond markets but can also amplify the likelihood of future surges. - Domestic bond yields are highly sensitive to external factors, especially for low-rated economies. ### Policy-relevant implications - Use distributional (capital-flows-at-risk) analysis to quantify likelihoods of extreme inflow or outflow outcomes and help policymakers prepare for future reversals or surges of portfolio flows. - Balance the benefits of attracting foreign investors (lower funding costs) with the risks of increased rollover risk and price volatility, particularly in frontier market economies. - Strengthen domestic financial market depth and expand the local investor base to mitigate yield and price volatility from higher foreign participation. - Improve liquidity in foreign currency markets and expand availability of hedging instruments to reduce exchange rate and funding cost pressures during episodes of risk aversion. *International Monetary Fund | April 2020 — Chapter 3 at a Glance* ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS ### Debt versus Equity Portfolio Flows - Global conditions disproportionately affect the outlook for large debt inflows; domestic fundamentals contribute more to the likelihood of negative or weak inflows. - Global financial conditions and specific global factors: - Easier global financial conditions shift the entire distribution of predicted debt flows to the right. - Lower volatility (VIX), lower US Treasury yields, and a weaker US dollar increase near-term debt inflows. - A 1 point increase in the FCI increases the average size of flows in the lower tail of the predicted distribution by 0.06 percent of GDP and in the upper tail by 0.09 percent of GDP. - Lower US Treasury bond yields and a weaker US dollar increase the likelihood of strong debt inflows considerably more than they decrease the likelihood of negative or weak flows. - Risk aversion (VIX) affects strong and weak debt flows in roughly equal magnitudes. - Domestic fundamentals: - Stronger domestic growth reduces the likelihood of negative or weak debt inflows but does not by itself increase the likelihood of very large inflows. - Greater external vulnerabilities (higher short-term foreign currency debt relative to international reserves) are linked to a larger likelihood of negative or weak debt inflows; when short-term debt is higher today, the likelihood of very strong inflows increases too, but to a lesser extent. - Deeper domestic financial markets improve the outlook for debt flows across the board. - COVID-19 impacts: - Downgraded GDP forecasts imply a greater likelihood of weak or negative debt flows. - Tightened global financial conditions reduce the likelihood of large inflows in the near term. - The strengthening of the US dollar and higher market volatility alone weaken the median predicted quarterly flows by 1 percent of GDP for an average emerging market economy. - During the last quarter of 2008, the US Dollar Index and the VIX increased by about 10.5 points and 33.5 points, respectively. As of mid-March 2020, the US Dollar Index and the VIX were 10.5 points and 43 points higher, respectively, than at the end of 2019. - Equity flows (contrasts with debt): - Equity flows are less sensitive to global factors than debt flows; the disproportionately larger impact on the likelihood of strong inflows is present only for debt flows. - A stronger US dollar weakens the near-term outlook for equity flows across the board, but its impact is an order of magnitude smaller than for debt flows. - Stronger domestic growth contributes more to an increased likelihood of strong equity inflows than to strong debt inflows. - Deeper domestic financial markets do not reduce the likelihood of negative or weak equity inflows in the same way they do for debt flows. - Summary bullet points from Figure captions/text: - ... while higher global interest rates disproportionately limit the likelihood of very large inflows. - A stronger US dollar reduces the likelihood of strong flows more than it increases the likelihood of weak or negative flows, more so for debt flows than for equity flows. - Higher debt vulnerability is negative for debt flows in general, but it increases the likelihood of negative or weak inflows much more than it increases the likelihood of large inflows. - Deeper financial markets reduce the likelihood of negative or weak debt inflows and increase the likelihood of large inflows of both types of flows. - Tighter global financial conditions today decrease near-term debt flows in general. - The risk aversion of global investors affects the outlook for debt flows across the board ... ### Hard Currency versus Local Currency Debt Portfolio Flows - General: - Better domestic fundamentals and economic prospects improve the outlook for both local and hard currency debt portfolio flows. - Local currency flows are more sensitive to domestic factors than hard currency flows. - External vulnerabilities: - Local currency debt flows are more sensitive to the level of external vulnerabilities than hard currency flows. - A 1 percentage point rise in the ratio of short-term debt to international reserves could lower the local currency debt flows at risk by 0.4 percent of GDP and hard currency debt flows at risk by 0.2 percent of GDP. - Domestic growth: - Higher growth boosts expected flows and affects the tails of the portfolio flow distribution twice as much. - Better growth prospects limit the likelihood of weak or negative inflows but also amplify the likelihood of very large inflows. - The outlook for local currency flows is almost three times more sensitive to domestic growth than the outlook for hard currency flows. - Market depth: - Deeper domestic financial markets improve the outlook for both hard currency and local currency flows and significantly limit the likelihood of negative or weak flows. - The probability of significant bond outflows (equivalent to the 5th percentile of historical events) declines from about 35 percent to less than 10 percent when market depth increases by one standard deviation. - Global financial conditions: - Tighter global financial conditions decrease expected portfolio flows and disproportionately affect the likelihood of extreme flows. - Hard currency flows are almost twice as sensitive as local currency flows to changes in global financial conditions. - The larger sensitivity of hard currency flows to global factors may reflect that hard currency bonds are typically held by global investors and the attendant exchange rate volatility and its impact on issuers’ repayment capacity. - Investor base: - Median foreign ownership of emerging market local currency bonds is just about 20 percent. ### Impact of Portfolio Flows on the Level and Volatility of Funding Costs - Pricing influences: - Sovereign debt pricing is linked to country-specific fundamentals and global investors’ risk appetite. - Strong domestic fundamentals help lower funding costs; tight global financial conditions can widen spreads. - Global risk appetite becomes especially relevant during periods of stress because it can interact with domestic vulnerabilities to amplify impacts on borrowers with weaker fundamentals. - Foreign participation in local currency bond markets: - Nonresident holdings can reduce borrowing costs, currency mismatches, and rollover risks associated with external borrowing; they diversify the investor base and can increase market size beyond domestic absorption capacity. - Foreign investor decisions can strengthen the link between exchange rate fluctuations and domestic financial conditions; reductions in foreign positions can create domestic debt rollover risks. - Local currency bond outflows can increase term premiums and long-term interest rates, affecting domestic activity. - Foreign holdings can transmit global financial shocks to local currency sovereign bond markets by increasing yield volatility and, beyond a threshold, amplifying spillovers from global shocks. - Financial market depth: - Depth helps mobilize savings, promote information sharing, diversify risk, buffer the economy against external shocks, and dampen asset price volatility. - Deepening has benefits but may also entail a “too much finance effect.” - Funding cost sensitivities: - Stronger domestic fundamentals are associated with lower funding costs. - High inflation increases local currency bond yields; better growth prospects contribute to lower yields. - Elevated vulnerabilities and lower buffers (higher external debt, lower foreign exchange reserves) are associated with higher local currency yields. - IMF staff analysis suggests sensitivity of local currency bond yields to the level of foreign exchange reserves has increased in recent years, while sensitivity to external debt appears to have declined somewhat. *Italic: Source — CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS (IMF Global Financial Stability Report, April 2020).* ### 2. Sensitivity of Local Currency Yields to Reserves/GDP and ### 2. Sensitivity of Local Currency Yields to Reserves/GDP and External Debt/Exports ### Key empirical findings on yield sensitivity and investor base - Funding cost is lowered by stronger domestic fundamentals and higher foreign participation. - Local currency bond yields have become more sensitive to reserve adequacy and less sensitive to the level of external debt. - Scaling examples (as reported in the source panel): - For every 10 basis point increase in growth, yields change by –0.9 basis points. - For every 1 percentage point increase in external debt (to exports), yields change by 1 percentage point. - Credit-rating and global risk-sentiment effects: - A 100 basis point increase in US BBB-rated corporate spreads could widen yields of high-yield emerging market bonds by almost 100 basis points, compared with only 40 basis points for investment-grade issuers. - Hard-currency bond spreads, especially for high-yield issuers, are affected about 60 percent more by global risk aversion shocks than local-currency spreads. - Inflation and growth effects on spreads: - Every percentage point rise in inflation increases local currency bond spreads by more than 70 basis points, but increases hard currency bond spreads by only 20 basis points. - GDP growth has a greater impact on hard currency bond spreads than on local currency spreads. - Ratings convergence: - For 80 percent of the countries in the sample, there is currently no difference between the local and foreign currency rating, compared with 50 percent at the time of the global financial crisis and 20 percent during the Asian financial crisis. - The convergence has been driven by a worsening of local currency ratings. - Market composition: Local currency bonds now account for almost 90 percent of the marketable emerging market fixed-income universe compared with 75 percent in 2008. ### Volatility of funding costs and role of foreign participation and market depth - IMF staff analysis: greater foreign participation in local currency bond markets increases the volatility of yields after it reaches a certain threshold; further domestic financial deepening helps reduce volatility. - Threshold effects and magnitudes: - When the size of foreign investor bond holdings exceeds about 40 percent of the country’s international reserves, the volatility of yields is found to increase by about 15 percent. - On average, domestic financial market deepening helped emerging market economies dampen volatility by 39 percent during 2004–17. - Table 3.1 estimates (sample: quarterly data from 18 emerging market economies during 2004–17; observations = 741): coefficients for the interaction of Financial Market Depth and Dummy: Foreign Participation at thresholds (Percent): - Threshold 37: Financial Market Depth –1.051*** ; Dummy: Foreign Participation 0.009 - Threshold 38: Financial Market Depth –1.029*** ; Dummy: Foreign Participation 0.060 - Threshold 39: Financial Market Depth –1.015*** ; Dummy: Foreign Participation 0.090 - Threshold 40: Financial Market Depth –0.980*** ; Dummy: Foreign Participation 0.147** - Threshold 41: Financial Market Depth –0.969*** ; Dummy: Foreign Participation 0.163** - Threshold 42: Financial Market Depth –0.967*** ; Dummy: Foreign Participation 0.205*** - Threshold 43: Financial Market Depth –0.980*** ; Dummy: Foreign Participation 0.188** - Significance levels: ***p < 0.01; **p < 0.05; *p < 0.1. ### Frontier markets: foreign participation, liquidity, and rollover risks - Strong investor interest in frontier markets in 2017–19 increased nonresident exposures in FX and local currency bond markets; Egypt and Nigeria had large overweight exposures concentrated in high-yielding short-term debt segments. - Empirical observations during COVID-19 turbulence: economies with greater nonresident investor participation experienced larger yield increases and higher exchange rate volatility; some frontier markets saw 12-month nondeliverable forwards depreciate by more than 20 percent. - Frontier market structural features: generally shallower domestic investor base, lower financial depth, larger bid-offer spreads, and higher price impact of trades relative to emerging markets; many frontiers rank well below the emerging market median on financial market and institutions depth indices. - Development impacts (model-based): bringing a frontier market’s financial depth to the emerging market average could: - Lower the volatility of its local currency bond yield by almost 30 percent. - Improve the portfolio debt flow outlook by 1.2 percent of GDP, on average. - Reduce the probability of net nonresident outflows by 15 percentage points. ### Policy priorities and recommendations - General principles: policy responses depend on the shock type (liquidity vs solvency), fiscal and monetary space, market depth, and balance-sheet vulnerabilities. Common guiding principles include tailored interventions across foreign exchange, capital flows, sovereign debt management, and macroprudential settings. - Foreign currency interventions: - For countries with flexible exchange rates, credible monetary frameworks, low inflation, deep financial markets, and absence of large currency mismatches: let the exchange rate be a key shock absorber. - For countries with adequate reserves: exchange rate intervention can lean against market illiquidity and mute excessive volatility, but should not prevent necessary adjustments; interventions should be based on expectation that pressures could last several months or longer. - For fixed or tightly managed regimes (including some major oil exporters and frontier markets): if reserves are adequate, maintaining the regime may be best short-term; interventions may need support from monetary tightening and possibly capital flow management measures, with policies premised on outflow pressures lasting several months or longer. - Capital flow management measures: - In an imminent crisis, capital outflow management measures can be part of a broad package but cannot substitute for warranted macroeconomic adjustment. - If nonresident outflows drive overall outflows, consider minimum holding periods, caps, and other limits on nonresidents’ transfers abroad, implemented transparently, temporarily, and lifted once crisis conditions abate, with due regard to international obligations. - Sovereign debt management strategy: - Prepare for long-term external funding disruptions. - Countries with continued market access at reasonable rates should actively decrease rollover risks; lowering rollover risks should take priority over containing costs when downside risks to market access are large. - Consider interactions between government financing strategy and domestic private/state-owned issuers to avoid exacerbating risks. - Macroprudential policy: - If macroprudential buffers exist, relaxing these tools can reduce the shock’s impact on market conditions and the economy. - Examples: relax foreign currency reserve requirements to mitigate FX funding pressures; allow banks to use liquidity coverage ratio buffers in foreign currency or relax the requirement. ### Longer-term priorities for frontier market development - Frontier market economies with less-developed financial systems should prioritize local capital market development and promotion of a stable, diversified local investor base, requiring coordination and sequencing of reforms. Specific measures include: - Developing efficient money markets. - Strengthening primary market practices to enhance transparency and predictability of issuance. - Bolstering market liquidity. - Developing a robust market infrastructure. *Source: IMF staff analysis as presented in the chapter "2. Sensitivity of Local Currency Yields to Reserves/GDP and External Debt/Exports" from the April 2020 Global Financial Stability Report chapter content.* ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS ### CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS ### Key findings - During periods of strong investor appetite, macroprudential tools may be put in place or tightened preemptively—before an inflow surge occurs—and maintained over the long term or permanently to build resilience and/or contain the buildup of systemic financial risk. - Policymakers should weigh all evidence about encouraging the participation of foreign investors beyond a level considered prudent after taking into account the capacity of their local markets to absorb external shocks without excessive volatility. - When local markets are at an early stage of development and there is limited room to adjust macroeconomic policies, authorities should proceed with caution when it comes to liberalizing portfolio inflows. - Countries with portfolio flow restrictions that intend to liberalize might consider a gradual approach by moving toward either quantitative limits or price-based restrictions (for example, taxes, reserve requirements) that could mitigate the risk of excessive inflows. - Establishing a sound legal and regulatory framework for securities is part of the broader set of measures to manage volatile portfolio flows. ### Policy recommendations - Implement or tighten macroprudential tools preemptively during episodes of strong investor appetite to build resilience and limit systemic risk. - Assess the prudent level of foreign investor participation by explicitly accounting for local market capacity to absorb external shocks without excessive volatility. - Exercise caution when liberalizing portfolio inflows in early-stage local markets or when macroeconomic policy space is limited. - Favor gradual liberalization strategies for countries moving away from portfolio flow restrictions: - Transition toward quantitative limits; or - Use price-based restrictions such as taxes and reserve requirements to mitigate excessive inflows. - Strengthen the legal and regulatory framework governing securities markets to support stable foreign participation. ### Implementation considerations - Preemptive application and, where appropriate, long-term or permanent maintenance of macroprudential measures can reduce the likelihood that sudden inflow surges lead to systemic financial stress. - The choice between quantitative limits and price-based restrictions should reflect domestic market structure, institutional capacity, and the objective of minimizing distortion while containing risks. - Policymakers need comprehensive evidence on market absorption capacity and potential spillovers before encouraging higher levels of foreign participation. - Gradual approaches to liberalization can provide flexibility to recalibrate measures if market development or macroeconomic conditions change. *CHAPTER 3 EMERGING AND FRONTIER MARkETS: MANAGING VOLATILE PORTFOLIO FLOwS.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/ch3.pdf_