The Local Stress Index: A New Tool to Summarize Local Market Conditions, and an Application to the South African Local Market
IMF News, October 27, 2020
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- Published: October 27, 2020
Context and motivation
- Speech by Tobias Adrian, Financial Counsellor and Director, Monetary and Capital Markets Department, International Monetary Fund — October 27, 2020.
- Motivation: need for policymakers to monitor signals from increasingly complex local financial markets, where currency and interest-rate derivative markets have grown and non-residents have become dominant players in select local-currency bond markets.
- Reference: introduced in Chapter 2 of the October 2020 edition of the IMF’s Global Financial Stability Report.
Local Stress Index (LSI) — definition and construction
- The LSI is constructed from local currency market liquidity and stress indicators.
- Key inputs include:
- bid-offer spreads,
- realized volatility,
- other risk-premium measures for local currency bonds and exchange rates.
- The LSI aggregates multiple liquidity, activity and risk-premia indicators and captures contagion effects by considering increases in correlations during crises.
- Methodological lineage: approach pioneered by the European Central Bank for the SovCiss index; IMF applies it to a broad set of Emerging Markets.
Key empirical findings (global Emerging Markets and COVID-19)
- The LSI shows overall stress in EM local markets comparable to the impact of the Global Financial Crisis of 2008 and 2009.
- The pace of deterioration and subsequent normalization during COVID-19 was unprecedented.
- Distinct behavior between currency and bond markets:
- Currency markets: stress was less severe and conditions normalized more quickly.
- Contributing factors: rapid policy response by major central banks (including dollar liquidity lines by the Federal Reserve), structural changes such as decentralization and greater electronic trading.
- Local currency bond markets: stress was larger than in recent crises, including 2008–2009.
- Three significant contributing factors:
- COVID-19 response skewed toward fiscal policy, increasing bond supply risks.
- Greater integration of Emerging Market local bond markets with the global financial system; non-residents often the largest investors.
- Local market depth did not match higher non-resident participation; domestic investor base often underdeveloped, with domestic banks frequently the sole alternative liquidity providers.
South Africa — case study and LSI application
- South African markets among the most developed in Emerging Markets.
- Non-resident holdings of local government bonds stood around 35 percent of the total debt stock just before the pandemic.
- Currency market:
- Experienced significant pandemic-related stress peaking in early April.
- Realized and options-implied volatility jumped to levels not seen since the Global Financial Crisis.
- Dollar liquidity shortage (currency basis) was much less pronounced compared to the 2008–2009 crisis.
- Widening of bid-ask spreads was limited.
- Domestic bond market:
- Experienced an unprecedented shock when analyzed via the LSI and has not yet fully normalized.
- Pre-pandemic concerns included weak growth, limited fiscal-policy space, elevated asset swap spreads, and a steep bond yield curve.
- A major credit downgrade coincided with the global FCI shock and led to the exclusion of local bonds from the World Government Bond Index.
- Result: large outflows, elevated volatility, deterioration of liquidity (widened bid-offer spreads) signaling severe distress.
- While volatility has subsided and bid-offer spreads have normalized, the risk premium in the bond market remains elevated, reflecting bond supply risk and absence of non-resident inflows.
Broader cross-country pattern
- Similar pattern observed in other major Emerging Markets: Brazil, India, Indonesia, Mexico, Poland and Turkey.
- COVID-19 shock produced a “sudden stop” in local bond markets that had been reliable financing sources.
- Coinciding factors:
- Rapid growth in budget financing needs from fiscal stimulus.
- Exhaustion of conventional monetary policy space in several EMs, with policy rates reduced to all-time lows.
Policy responses: Asset Purchase Programs (APPs)
- Many Emerging Market economies introduced APPs for the very first time during the pandemic.
- Rationale for APPs:
- Increased credibility of Emerging Market central banks’ inflation-targeting regimes.
- Positive experience of Advanced Economies with APPs.
- Heterogeneity: programs varied in scope, scale and modality across countries.
- Aggregate impact (October 2020 GFSR analysis):
- APPs had a positive impact on bond markets by lowering yields, improving market liquidity, and reducing the overall level of stress as measured by the LSI.
- APPs did not lead to currency depreciation or increased stress in currency markets, as evident from the LSI.
- Countries that introduced APPs saw a swifter reduction of stress in local markets compared with countries without such programs.
- Caveat: further research is needed as APPs progress and diverge across countries.
Policy implications and recommendations
- The LSI can serve as a yardstick for policymakers to measure financial-market stress across multiple indicators and to capture contagion effects.
- Monitoring both currency and bond market dimensions is essential because they can behave differently during crises.
- Strengthening domestic investor bases and market depth can reduce vulnerability to non-resident outflows.
- Where conventional monetary policy is exhausted, carefully designed APPs can help restore market functioning without provoking currency stress, but cross-country monitoring and further research is required.
Next steps and dissemination
- IMF will continue developing the LSI and share results in an upcoming IMF Working Paper and through other avenues.
- The LSI aims to be a useful tool for policymakers in Advanced Economies and Emerging Markets alike.
Source: Speech by Tobias Adrian, Financial Counsellor and Director, Monetary and Capital Markets Department, International Monetary Fund, October 27, 2020.