By Erik Feyen, Swati Ghosh, Katie Kibuuka, and Subika Farazi
In the wake of the Global Crisis, various developed economies pursued unprecedented, extraordinary monetary policies (EMPs) to rekindle domestic economic growth and battle disinflationary pressures. This was done mainly via (promises of future) ultra-low policy rates and large-scale asset purchasing programmes (LSAPs) designed to lower long-term interest rates. The spillover effects of these monetary policies on emerging and developing economies (EMDEs) have been profound— emerging economies experienced an unparalleled surge in total gross capital inflows from an annual average of $0.5 trillion during 2000-2007 to $1.1 trillion during 2010-2013. Developing countries’ external bond issuance, which had been increasing steadily before the Crisis, accelerated rapidly post-crisis due to the extraordinary policies and has now reached unprecedented levels. Indeed, recent research shows that bond markets have become a major transmission channel of global liquidity (e.g. Shin 2013, Avdjiev et al. 2014). So what are some of the major issuance trends observed in emerging and developing countries?
During 2009-14, corporates and sovereigns in emerging economies cumulatively issued $1.5 trillion in external bonds, almost a tripling from $520 billion in 2002-07. The recent surge in issuance is driven by corporates, which have issued a total of about $300 billion in 2014 compared to $14 billion in 2000 (Figure 1) and most of this issuance denominated in foreign currencies (Figure 2). Cumulative post-crisis issuance relative to the size of the economy has risen to unprecedented levels, a phenomenon that is widespread and not driven by a single country or region (Figure 3). For all emerging and developing economies combined, the median cumulative external issuance to GDP ratio was 6.7% in 2009-14, a significant increase from 4.3% in 2002-07. Most of the increase across regions occurred after 2009 and 2011 when large-scale asset purchasing programmes in the US were fully operational and the long-term refinancing operations (LTROs) of the ECB were launched, respectively.
Average yields of new external issuances and spreads have dropped sharply since the Crisis. In 2007, yields stood at 8.4% and have fallen since to about 5% in 2015. The average maturity of external issuances also decreased sharply during the Crisis. Before the Crisis, average maturities were almost 9 years and dropped to 7.3 years in 2009. While maturities have increased since (currently around 8 years), they still remain below pre-crisis levels.
Global Factors and External Bond Issuance by Emerging Economies
The pronounced surge in capital flows to emerging and developing economies seen since 2009-10 is not a new phenomenon. Extensive literature from the 1990s (e.g. Calvo et al. 1993 and Fernandez-Arias 1996) emphasised the importance of global push factors for capital flows. These flows to developing countries have long tended to exhibit strong co-movements, suggesting that common drivers in the global environment are at play—both across types of flows (with the exception of FDI flows) and across geographical regions. This observation is corroborated by Koepke (2015), who summarises relevant empirical literature and concludes that global push factors matter more for portfolio flows. Country pull factors, which also determine portfolio flows, matter more for banking flows.
In a new working paper (Feyen et al. 2015), we analyse the impact of global liquidity factors on external issuance of bonds by emerging economies’ corporates and sovereigns to shed light on the following questions:
- What is the impact of global factors—proxied by financial conditions in the US—on the propensity to issue external bonds by an emerging country-industry compared to its historical issuance average?
- What is the impact of these global factors on two important bond characteristics at the time of issuance: its yield (and spread) and maturity?
- Does the risk-taking channel through exchange rate appreciation as described and tested in Bruno and Shin (2015a, 2015b) also operate in a similar fashion for external bond issuance by developing economies?
Besides documenting recent trends in bond flows, stocks, pricing, and maturities across emerging economies, our analysis makes three novel contributions. We are the first to study the impact of global factors on primary activity of developing economies’ entities in international bond markets since the start of new millennium. Secondly, we find support for the risk-taking channel of exchange rate appreciation for external bond issuance. Thirdly, we analyse bond micro-data at the country-industry or bond-tranche level, accounting for industry-specific and deal-specific factors (e.g. currency, bond riskiness, bond size). This ameliorates bias due to compositional and selection effects that are present in aggregated capital flows data, which are typically the focus of inquiry in the literature.
The datasets used in our paper cover the universe of emerging countries’ external bond issuance from 2000 to 2014 and match three types of data: highly granular bond data (i.e. bond size, industry and currency of issue, bond riskiness, type of borrower, etc.); high frequency financial global push factors (VIX index, Libor-OIS spread, corporate risk spread, and size of Fed’s balance sheet); and country pull factors (GDP per capita, growth rate, current account balance, external debt, bank credit to private sector).
Propensity to Issue External Bonds
To study the tendency of emerging country-industries to issue external bonds above their historical average, we fit logistic regressions on an industry-level panel dataset. The dataset is a balanced panel of monthly total external bond issuance for 7 different industrial sectors in 71 emerging and developing economies between 2000 and 2014. The dependent variable is a dummy that denotes whether the total volume issuance by a particular country-industry in a given month is above its historical average over the period 2000-07. The regressions include the global push and domestic pull factors along with a battery of fixed effects to account for time-invariant country factors (such as the overall institutional environment, the macro-financial framework, and the level of development of the country, which influences investment opportunities and investor appetite); year factors (to capture the overall impact of global conditions such as trade and crisis effects) and finally industry factors (to capture industry specific effects).1
We find all four global push factors to be highly statistically significant and our results support the notion that external issuance across emerging countries is highly synchronised with the global financial cycle. In particular, our regression analysis finds that a 10% increase in:
- VIX index decreases the odds an industry will issue above its average by almost 6%.2
- Fed’s balance sheet increases the tendency of above average issuance by 8%.
- LIBOR-OIS spread decreases the propensity of above average issuance by 5.5%.
- Corporate risk spread decreases the odds of above average issuance by 10%.
GDP per capita, growth rate, and current-account-balance are the most important country pull factors.
Yields and Maturities of External Bonds at Time of Issuance
We use pooled OLS regressions on a bond tranche-level dataset to evaluate the impact of global factors on the pricing and maturity of bonds. The dataset used captures the universe of 6,307 individual bond deals for 71 emerging and developing economies in the 2000-14 period. The first dependent variable, yield to maturity, is defined as the rate of return on a bond assuming the bond is held until maturity at the time of issuance, while maturity is defined as the number of years for which the bond remains outstanding at the time of issuance. Besides including global push variables, the regressions also control for domestic pull factors, bond-specific characteristics, and two sets of fixed effects – year of bond issuance and country of issuance.
Regression results show that favourable global conditions reduce bond yields across emerging countries in a synchronised manner, and increase investor willingness to lengthen maturities.3 The regression analysis finds that a 10% decrease in:
- VIX decreases emerging countries’ bond ‘spreads’ by 6 to 12 basis points and extends maturities by 16-17 weeks.4,5
- Fed’s balance sheet size increases countries’ bond spreads by 8-9 basis points and decreases maturities by 14 weeks.
- LIBOR-OIS spread decreases bond spreads by 3-6 basis points while maturities are not significantly affected.
- Corporate risk decreases bond spreads by 12-13 basis points and boosts maturities by 17-24 weeks.
The size of the bond does not explain bond spreads significantly, but larger bonds are typically associated with longer maturities. After including year fixed effects, the domestic pull factors are not significant for both spreads and maturities, suggesting that global factors play a more significant role.
The Risk-Taking Channel of Exchange Rate Appreciation
Following Borio and Zhu (2012) and Bruno and Shin (2015a, 2015b), we analyse the risk-taking channel of financial conditions and monetary policy in developed countries via exchange rate appreciation.6 In doing so, we use two exchange rate variables as global push factors: the US real effective exchange rate (USREER) and the real US dollar to the local currency exchange rate. Our analysis shows that the propensity to issue bonds externally above historical average volumes is significantly higher when the US dollar depreciates in real terms. In other words, when the local currency appreciates, local borrowers’ balance sheets strengthen. This, in turn, increases their external borrowing capacity which triggers higher cross-border flows from international investors who are willing to take on more risk. These results confirm another channel through which the VIX operates, similar to Bruno and Shin (2015b) who find a link between the VIX and USREER.
Some Policy Implications
Our findings provide strong support for highly synchronised primary issuance flows across emerging and developing economies driven mostly by global factors. Both sovereigns and corporates in these markets have collectively been able to take advantage of ample international liquidity by lowering their borrowing costs and extending maturities which can improve risk profiles (although in the wake of the Crisis, maturities in emerging markets remain well below pre-crisis levels).
However, the massive and widespread external issuance in developing countries raises important questions regarding the impact of pro-cyclical investor behaviour once the global cycle winds down, or if global shocks materialise, with potential systemic implications for emerging markets. Furthermore, while issuance at lower cost and maturity extension can help lower individual borrower risk profiles, large foreign currency exposures raise risks, particularly for unhedged issuers. The recent trend of a rapidly strengthening US dollar against most emerging economies’ currencies further heightens currency risks.
In this context, the inevitable exit from extraordinary monetary policies will tighten international funding conditions which could prove disruptive for emerging countries. Additionally, fragility in these economies can be further compounded by their shallow local financial markets and a lack of strong institutions, supervisory and surveillance capacity, technical experience, and (macro-) prudential tools. Going forward, there is a continued need to strengthen financial sector policies in emerging economies, including: create vibrant local currency (corporate) bond markets and an active, diverse domestic investor base; build comprehensive macro-prudential tools and monitor financial markets closely; and strengthen the banking sector to safeguard against potential spillovers.
Subika Farazi is a Financial Sector Specialist in the Finance and Markets Global Practice, World Bank Group. Erik Feyen is the Lead Financial Sector Economist in the Financial Systems Global Practice, World Bank. Swati Ghosh is an Economic Adviser in the Macro Fiscal Management Global Practice, World Bank. Katie Kibuuka is a Financial Sector Specialist in the Finance and Markets Global Practice, World Bank Group.
Avdjiev, S, M Chui, and H S Shin (2014), “Non-Financial Corporations from Emerging Market Economies and Capital Flows”, BIS Quarterly Review, December 2014.
Borio, C and H Zhu (2012), “Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?”, Journal of Financial Stability, 8(4), pp. 236-251.
Bruno, V and H S Shin (2015a), “Cross-Border Banking and Global Liquidity”,Review of Economic Studies 82, pp. 535-564.
Bruno, V and HS Shin (2015b), “Capital Flows and the Risk Taking Channel of Monetary Policy”,Journal of Monetary Economics 71, pp. 119-132.
Calvo, G, L Leiderman, and C Reinhart (1993), “Capital Inflows and Real Exchange Rate Appreciation in Latin America: the Role of External Factors,” IMF Staff Papers: 108-151.
Feyen, E, S Ghosh, K Kibuuka, and S Farazi (2015), “Global Liquidity and External Bond Issuance in Emerging Markets and Developing Economies”, World Bank Policy Research Working Paper 7363.
Fernandez-Arias (1996), “The New Wave of Private Capital Inflows: Push or Pull?”, Journal of Development Economics 48, no. 2: 389-418.
Koepke, R (2015), “What Drives Capital Flows to Emerging Markets? A Survey of the Empirical Literature”, Institute of International Finance Working Paper.
Shin, H S (2013). “The Second Phase of Global Liquidity and Its Impact on Emerging Economies”, mimeo Princeton University.
1 All regressions (for issuance propensity and bond maturities and spreads) also control for the US 10-year Treasury yield, a proxy for global liquidity conditions. For the industry-level dataset, for each month the average value of each global push factor for the 6 preceding months is used while for the bond-level dataset, for each individual bond the average value for each push factor 6 months prior to the issuance date is used. Standard errors are clustered at the country-industry level to allow for within industry correlation. See Feyen et al. (2015) for more details.
2 As one of the robustness checks, we use the MOVE index (Merrill lynch Option Volatility Estimate – which captures expected US Treasury volatility and acts as a proxy for interest rate uncertainty) in our regressions and obtain qualitatively similar results as for the VIX.
3 We also ran some rounds excluding Chinese issuance to avoid a possible China bias since 2,945 bonds in the sample (consisting of 3,143 tranches) are issued by Chinese entities and generally our results hold.
4 Since the regressions control for the 10-year US treasury yield, the results can be interpreted in terms of ‘spread’ relative to US treasuries.
5 Again for yields and maturities, we use the MOVE index as a check for robustness of our results and obtain qualitatively similar results as for the VIX.
6 According to Bruno and Shin (2015b), looser financial conditions are associated with an increase in cross-border capital flows intermediated through higher leverage in the international banking system. The mechanism operates via stronger local borrower balance sheets as a result of local currency appreciation, allowing banks to lend them more and take on more risk.