## 1. Global Financial Conditions and Foreign Participation in EMs Government Bond Markets ## Source details **Canonical URL:** [1. Global Financial Conditions and Foreign Participation in EMs Government Bond Markets](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15141.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15141.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15141.pdf.json) --- ### Major themes - Interaction between global financial conditions and foreign participation in emerging markets (EMs) government bond markets. - International financial spillovers into EMs. - Non-linear (PSTR) estimation of global financial spillovers into EMs. ### Introduction and scope - Sample: quarterly data for 17 emerging market economies over 2004:Q1–2013:Q3. Countries: Argentina, Brazil, Colombia, Egypt, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, South Africa, and Thailand, and Ukraine. - Research question: role of foreign participation and investor-base concentration in transmitting global financial shocks into EM government bond markets; comparison of local-currency (LC) versus foreign-currency (FX) sovereign bonds. - Key global shock variables: U.S. 3 month t-bill rate (US3mt), U.S. 10-year Treasury bond rate (US10Y), and VIX (VIX). ### Empirical approach - Dependent variables: - Level and volatility of the 5-year local currency yield. - EMBI benchmark foreign currency yield. - Volatility measure: log of the standard deviation of weekly changes in the yield over each quarter (12 weeks). - Foreign participation (F_it): foreign holdings measured as percent of total government local-currency (or foreign-currency) denominated government debt (data from Arslanalp and Tsuda (2014)). - Investor-base concentration: Herfindahl index computed on 6 categories (foreign central bank, foreign bank, foreign non-bank, domestic central bank, domestic bank, domestic non-bank), normalized to range between 0 and 1. - Controls (X_it): (i) current account balance to GDP; (ii) real GDP growth (or volatility of growth); (iii) inflation; (iv) forward exchange rate volatility. Country fixed effects and time effects included. - Endogeneity addressed via: - instrumenting foreign participation with two quarter lags; - instrumenting with predicted foreign holdings from a geographical “financial remoteness” measure (natural log of great-circle distance to London, New York, or Tokyo). ### Key empirical findings — level and volatility of yields - LC bonds: - Higher foreign participation increases yield volatility but decreases yield level. - Tables 2 and 4: positive association between foreign participation and LC bond yield volatility; significance appears when instrumenting foreign holdings with lags or remoteness-based instrument. - LC yield level: foreign holdings ratio coefficient (IV REMOTENESS IV) shows -0.0810*** (Table 4, column 3). - FX bonds: - Foreign holdings of FX-denominated bonds are not found to have an impact on either the level or the volatility of FX bond yields (Tables 1 and 3). - Macroeconomic fundamentals: - Higher indebtedness and higher output growth volatility increase yield volatility. - Higher real GDP growth decreases level and volatility of both LC and FX bond yields. - Higher inflation is positively associated with the level of bond yields. ### Transmission of global shocks conditional on foreign participation and investor concentration - Model: interacted global shock variables (US3mt, US10Y, VIX) with indicators D that equal 1 if lagged foreign participation (or Herfindahl concentration) ≥ threshold D* (D ranges tested: 10 to 40 percent for foreign participation; 0.1 to 0.25 for concentration). - Foreign participation thresholds and illustrative magnitudes: - Threshold around 30–35 percent amplifies transmission of global shocks. - When foreign holdings of LC bonds > 35 percent: - a 100 bps increase in U.S. 10-year yield results in an EM LC yield increase of around 140 bps (versus 40 bps below the 35 percent threshold). - Past 30 percent foreign participation: - a 100 bps increase in U.S. short-term interest rates increases EM yields by 140 bps (compared with no significant impact below the threshold). - Around 32 percent foreign participation: - a two-standard deviation shock in the VIX translates to a 130 bps increase in yields (compared to no significant impact below the threshold). - Investor-base concentration (Herfindahl) threshold: - Threshold around 0.2: - a 100 bps increase in the U.S. 10-year yield raises LC sovereign yields by 70 bps when Herf > 0.2, compared with 30 bps when Herf ≤ 0.2. - Non-linear coefficient evidence (Table 5): - U.S. 10-year yield * 1[FH>35]: 0.958*** (Column 1). - VIX * 1[FH>32]: 0.0692** (Column 2). - U.S. 3-month * 1[FH>30]: 1.332*** (Column 3). - U.S. 10-year yield * 1[Herf>0.2]: 0.385** (Column 4). ### Robustness: Panel Smooth Transition Regression (PSTR) results - PSTR framework: smooth regime transitions via logistic transition function with parameters δ (threshold) and γ (smoothness). - Tests reject linearity in favor of PSTR. - Estimated thresholds broadly align with rolling-threshold results: - PSTR suggests foreign participation threshold close to 40 percent for some specifications (slightly higher than the 35 percent rolling-threshold). - Diversity (Herfindahl) threshold similar at 0.2. - Transition characteristics: - Transition function smooth for U.S. 10-year effect. - Sharper transitions for US3mt, VIX, and diversity specifications. - Conclusion: consistency of threshold ranges across methodologies is reassuring, though values are indicative. ### Limitations - Absence of detailed data on the profile of foreign investors (retail vs institutional) holding LC government bonds limits generalization of thresholds. - Most countries reached identified foreign participation thresholds after the global financial crisis; threshold results are thus heavily dependent on the post-crisis period. - Endogeneity concerns addressed via lags and instruments, but remain an important consideration. ### Policy-relevant implications and recommendations - Foreign participation effects: - Greater foreign participation in LC sovereign bond markets provides additional financing and lowers average yields but increases yield volatility. - No similar effect detected for FX-denominated sovereign bonds. - Amplification and mitigation of spillovers: - High foreign participation (≈30–35 percent) amplifies transmission of global financial shocks (US short- and long-term rates; global risk aversion). - A more diversified investor base (Herfindahl below ≈0.2) attenuates shock transmission; policy efforts to broaden investor base and promote asset diversification could improve resilience. - Strong macroeconomic fundamentals (low inflation, strong and stable output growth, moderate public debt levels, higher international reserves) help reduce level and volatility of sovereign yields and dampen adverse spillovers. - Practical considerations for policymakers: - Countries increasing reliance on foreign investors in LC markets have a stronger case for preserving prudent macroeconomic environments to insulate against external shocks. - Monitoring foreign participation shares (notably around 30–40 percent) and investor-base concentration metrics can inform financial-stability assessments and policy calibration. *Source: _wp15141 - 1. Global Financial Conditions and Foreign Participation in EMs Government Bond (PDF).* ### 1. Global Financial Conditions and Foreign Participation in EMs Government Bond ### 1. Global Financial Conditions and Foreign Participation in EMs Government Bond Markets ### Major themes - Interaction between global financial conditions and foreign participation in emerging markets (EMs) government bond markets. - International financial spillovers into EMs. - Non-linear (PSTR) estimation of global financial spillovers into EMs. ### Section breakdown (as presented) - 1. Global Financial Conditions and Foreign Participation in EMs Government Bond Markets ______________________________________________________________13 - 2. International Financial Spillovers into EMs ____________________________________14 - 3. PSTR Estimates of Global Financial Spillovers into EMs _________________________15 ### Tables listed - 1. Foreign Holdings of FX Debt and Yield Volatility. Period 2004:Q1–2013:Q2 _________16 - 2. Foreign Holdings of LC Debt and Yield Volatility. Period 2004:Q1–2013:Q2 _________17 - 3. Foreign Holdings of FX Debt and FX Yield Level. Period 2004:Q1–2013:Q2 _________18 - 4. Foreign Holdings of LC Debt and LC Yield Level. Period 2004:Q1–2013:Q2 _________19 - 5. Panel Non-Linear Estimates ________________________________________________20 *Source: _wp15141 - 1. Global Financial Conditions and Foreign Participation in EMs Government Bond (PDF).* ### References _______________________________________________________________21 ### _wp15141 - References _______________________________________________________________21 ### Introduction and scope - Sample: quarterly data for 17 emerging market economies over 2004:Q1–2013:Q3. Countries: Argentina, Brazil, Colombia, Egypt, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, South Africa, and Thailand, and Ukraine. - Research question: role of foreign participation and investor-base concentration in transmitting global financial shocks into EM government bond markets; comparison of local-currency (LC) versus foreign-currency (FX) sovereign bonds. - Key global shock variables used: U.S. 3 month t-bill rate (US3mt), U.S. 10-year Treasury bond rate (US10Y), and VIX (VIX). ### Empirical approach - Dependent variables: level and volatility of the 5-year local currency yield and EMBI benchmark foreign currency yield. - Volatility measure: log of the standard deviation of weekly changes in the yield over each quarter (12 weeks). - Foreign participation (F_it): foreign holdings measured as percent of total government local-currency (or foreign-currency) denominated government debt (data from Arslanalp and Tsuda (2014)). - Investor-base concentration: Herfindahl index computed on 6 categories (foreign central bank, foreign bank, foreign non-bank, domestic central bank, domestic bank, domestic non-bank), normalized to range between 0 and 1. - Controls (X_it): (i) current account balance to GDP; (ii) real GDP growth (or volatility of growth); (iii) inflation; (iv) forward exchange rate volatility. Country fixed effects and time effects included. - Endogeneity addressed via: (i) instrumenting foreign participation with two quarter lags; (ii) instrumenting with predicted foreign holdings from a geographical “financial remoteness” measure (natural log of great-circle distance to London, New York, or Tokyo). ### Key empirical findings — level and volatility of yields - Behavior differs across markets: - LC bonds: higher foreign participation increases yield volatility but decreases yield level. - Tables 2 and 4: positive association between foreign participation and LC bond yield volatility; significance appears when instrumenting foreign holdings with lags or remoteness-based instrument. - LC yield level: foreign holdings ratio coefficients (IV REMOTENESS IV) show -0.0810*** (Table 4, column 3). - FX bonds: foreign holdings of FX-denominated bonds are not found to have an impact on either the level or the volatility of FX bond yields (Tables 1 and 3). - Macroeconomic fundamentals: - Higher indebtedness and higher output growth volatility increase yield volatility. - Higher real GDP growth decreases level and volatility of both LC and FX bond yields. - Higher inflation is positively associated with the level of bond yields. ### Transmission of global shocks conditional on foreign participation and investor concentration - Model specification: interacted global shock variables (US3mt, US10Y, VIX) with indicators D that equal 1 if lagged foreign participation (or Herfindahl concentration) ≥ threshold D* (D ranges tested: 10 to 40 percent for foreign participation; 0.1 to 0.25 for concentration). - Threshold findings (baseline rolling-threshold and non-linear estimates): - Foreign participation threshold around 30–35 percent amplifies transmission of global shocks: - When foreign holdings of LC bonds > 35 percent, a 100 bps increase in U.S. 10-year yield results in an EM LC yield increase of around 140 bps (versus 40 bps below the 35 percent threshold). - Past 30 percent foreign participation, a 100 bps increase in U.S. short-term interest rates increases EM yields by 140 bps (compared with no significant impact below the threshold). - Around 32 percent foreign participation, a two-standard deviation shock in the VIX translates to a 130 bps increase in yields (compared to no significant impact below the threshold). - Investor-base concentration threshold around 0.2 (Herfindahl index): - A 100 bps increase in the U.S. 10-year yield raises LC sovereign yields by 70 bps when Herf > 0.2, compared with 30 bps when Herf ≤ 0.2. - Non-linear coefficient evidence (Table 5): - U.S. 10-year yield * 1[FH>35]: 0.958*** (Column 1). - VIX * 1[FH>32]: 0.0692** (Column 2). - U.S. 3-month * 1[FH>30]: 1.332*** (Column 3). - U.S. 10-year yield * 1[Herf>0.2]: 0.385** (Column 4). - Magnitude examples from narrative: - Past the 35 percent threshold, a 100 bps increase in the U.S. yields → ~140 bps rise in EM yields (vs. ~40 bps below threshold). - Past 30 percent threshold, a 100 bps increase in U.S. short-term rates → 140 bps increase in EM yields. - Two-standard deviation VIX shock at ~32 percent foreign participation → 130 bps increase in yields. ### Robustness: Panel Smooth Transition Regression (PSTR) results - PSTR used to allow smooth regime transitions; transition function logistic with parameters δ (threshold) and γ (smoothness). - Tests reject linearity in favor of PSTR. - Estimated thresholds similar to rolling-threshold results: - PSTR suggests foreign participation threshold close to 40 percent for some specifications (slightly higher than the 35 percent rolling-threshold). - Diversity (Herfindahl) threshold similar at 0.2. - Transition function smooth for U.S. 10-year effect; sharper transitions for US3mt, VIX, and diversity specifications. - Conclusion: consistency of threshold ranges across methodologies is reassuring, though values are indicative. ### Limitations noted in the paper - Absence of detailed data on the profile of foreign investors (retail vs institutional) holding LC government bonds limits generalization of thresholds. - Most countries reached identified foreign participation thresholds after the global financial crisis; threshold results are thus heavily dependent on the post-crisis period. - Endogeneity concerns addressed via lags and instruments, but remain an important consideration. ### Policy-relevant implications and recommendations - Foreign participation effects: - Greater foreign participation in LC sovereign bond markets provides additional financing and lowers average yields but increases yield volatility. - No similar effect detected for FX-denominated sovereign bonds. - Amplification and mitigation of spillovers: - High foreign participation (≈30–35 percent) amplifies transmission of global financial shocks (US short- and long-term rates; global risk aversion). - A more diversified investor base (Herfindahl below ≈0.2) attenuates shock transmission; policy efforts to broaden investor base and promote asset diversification could improve resilience. - Strong macroeconomic fundamentals (low inflation, strong and stable output growth, moderate public debt levels, higher international reserves) help reduce level and volatility of sovereign yields and dampen adverse spillovers. - Practical considerations for policymakers: - Countries increasing reliance on foreign investors in LC markets have a stronger case for preserving prudent macroeconomic environments to insulate against external shocks. - Monitoring foreign participation shares (notably around 30–40 percent) and investor-base concentration metrics can inform financial-stability assessments and policy calibration. *Source: _wp15141 - References _______________________________________________________________21* ### REFERENCES ### _wp15141 - REFERENCES ### References - Arslanalp, S. and T. Tsuda, 2014, “Tracking Global Demand for Emerging Market Sovereign Debt”, IMF Working Paper No. 14/39, International Monetary Fund. - Chami, R., D. Hakura, and P. Montiel, 2009, “Remittances: An Automatic Output Stabilizer?” IMF Working Paper No. 09/91, International Monetary Fund. - Combes, J. L., and C. Ebeke, 2011, "Remittances and Household Consumption Instability in Developing Countries", World Development 39.7 (2011): 1076–1089. - Ebeke, C. and Y. Lu, 2014, “Emerging Market Local Currency Bond Yields and Foreign Holdings in the Post-Lehman Period––a Fortune or Misfortune?”, IMF Working Paper No. 14/29, International Monetary Fund. - González, A., T. Teräsvirta, and D. Van Dijk, 2005, “Panel Smooth Transition Regression Models”, Research Paper No. 165, Quantitative Finance Research Centre, University of Technology, Sydney. - Hansen, B., 1999, “Threshold Effects in Non-Dynamic Panels: Estimation, Testing, and Inference”, Journal of Econometrics, 93 (2): 345–368. - IMF, 2014 Global Financial Stability Report, Moving from Liquidity- to Growth-Driven Markets, Chapter 2. “How Do Changes in the Investor Base and Financial Deepening Affect Emerging Market Economies?, April 2014 - Lim, J. J., S. Mohapatra, and M. Stocker, 2014, “Tinker, Taper, QE, Bye? The Effect of Quantitative Easing on Financial Flows to Developing Countries”, Background Paper for Global Economic Prospects 2014, Washington, DC: World Bank. - Masten, A., F. Coricelli, and I. Masten, 2008, "Non-Linear Growth Effects of Financial Development: Does Financial Integration Matter?" Journal of International Money and Finance, 27.2 (2008): 295–313. - Peiris, S. J., 2010, “Foreign Participation in Emerging Markets’ Local Currency Bond Markets (EPub)”, IMF Working Paper No. 10/88, International Monetary Fund. - Rose, A. K. and M. M. Spiegel, 2009, "International Financial Remoteness and Macroeconomic Volatility", Journal of Development Economics 89.2 (2009): 250–257. *Source: _wp15141 - REFERENCES* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15141.pdf_