Download Some Financial Stability Implications of Local Bond Markets

Some Financial Stability Implications
of Local Bond Markets
Mario Bergara
Central Bank of Uruguay
Conference on Global Finance in Transition
Istanbul, May 8, 2013
Some Financial Stability Implications
of Local Bond Markets
What domestic markets are expected to do for financial stability?
Local markets: trading place for financial assets issued under
domestic law regardless of the currency of denomination
Foreign investors used to stay out of domestic markets:
Lack of information
Transaction costs
Operational risks
Lower creditor protection
Other macro issues
However, this fact is rapidly reverting
Lacking arbitrage, these markets were seen as stable sources
of funding
Some Financial Stability Implications
of Local Bond Markets
What domestic markets are expected to do for financial stability?
Underdeveloped domestic
financial markets
Frequent non-country
specific crisis and sudden
stops
Reliance on foreign funding
and less capacity to issue
domestic currency debt
Overexposure to
external shocks
Some Financial Stability Implications
of Local Bond Markets
What domestic markets are expected to do for financial stability?
Reliance on external sources renders the country more subject
to external shocks and non-country specific financial crisis
Local markets development as a means to reduce financial
fragility
Keys to develop local markets and reduce currency mismatches:
Stronger institutions
Well defined creditor rights
Low inflation
More developed domestic financial market helps reduce the
volatility of capital flows to emerging economies
However, domestic market development entails new problems
when considering the impact on financial stability
Some Financial Stability Implications
of Local Bond Markets
Uncertainty and volatility in the global environment
Growth
differentials
Interest rate
differentials
Differential
expectations on
exchange rates
Liquidity
conditions and
market
sentiment
Implications of volatile capital flows for
macroeconomic and financial stability
Appreciating and volatile exchange rates in emerging markets
Risks of asset price bubbles
and bank lending boom
Risks of capital flow
stop or reversal
Some Financial Stability Implications
of Local Bond Markets
Inbound capital might generate trends of currency appreciation
Inbound capital movements set the grounds for currency
appreciation beyond the limits of other fundamentals
Another secular trend of new markets discovery by massive
investment funds adds further pressure on the exchange rate
Investment funds increasingly search for new alphas,
encouraged by historically low interest rates and buoyant
international liquidity
Not only the real sector suffers, but is also subject to foreign
and domestic sources of real exchange rate shocks
The domestic financial sector may be subject to solvency
issues related to sharp changes in this relative price
Some Financial Stability Implications
of Local Bond Markets
Inbound capital might generate trends of currency appreciation
6000
160
5000
Uruguay REER, 2010=100
140
4000
130
3000
120
110
2000
100
1000
90
0
80
Jan-13
Jul-12
Jan-12
Real Effective Exchange Rate
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
BoP - Financial Account
Uruguayan Financial Account (millions of USD)
150
Some Financial Stability Implications
of Local Bond Markets
Capital reallocation dampens the ability of monetary policy to
cope with internal stabilization issues
As foreign investors find more attractive to enter domestic
markets, they increase the aggregate demand for domestic
assets
Higher demand implies higher prices and lower yields, making
harder for the monetary authority to pursue an interest rate target
The Central Bank is forced to perform sterilized purchases of
foreign currency, to prevent sharp short term currency
appreciation and to satisfy the demand for domestic assets
FX market tensions risk diverting the monetary authority from its
primary target and might as well generate pressure on the
financial system
Prudential regulation and supervision have to pay special
attention to FX risk issues
Some Financial Stability Implications
of Local Bond Markets
Financial Stability and Policy Options
Central Banks in emerging economies have use reserve
requirements and caps on foreign exchange positions in order to
limit potential imbalances derived by surges in short-term capital
inflows
Macroprudential instruments to limit the exposure of the financial
system to systemic risks
Exchange rate flexibility acts as an automatic buffer to cushion
against external shocks and contribute to provide an adequate
incentive structure in the economy
Foreign exchange market intervention: reduce excessive volatility
and currency appreciation in the current (circumstantial) financial
environment, but not against long term fundamentals
The macroprudential perspective contributes with more instruments
to deal with short term capital flows, without affecting
macroeconomic and financial stability
Some Financial Stability Implications
of Local Bond Markets
Financial Stability Net
Prudential
Monetary Policy
Regulator and
Lender of Last
Resort
Supervisor
Deposit Insurer
and Resolution
Ministry of
Finance/
Agency
Treasury
Coordination and contribution for all agencies
to comply with their respective mandates
Some Financial Stability Implications
of Local Bond Markets
Globalization dampens the role of domestic markets as firewalls
35%
900
30%
800
700
Domestic Rates
600
20%
500
15%
400
10%
300
5%
200
0%
100
Nov-10
Sep-10
Jul-10
May- 10
Domestic Overnight Mkt Rate
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May- 09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
May- 08
Mar-08
Jan-08
EMBI Uruguay
Monetary Policy Rate
EMBI Uruguay, bps
25%
Some Financial Stability Implications
of Local Bond Markets
Domestic asset prices are increasingly determined
by external factors
External financial episodes directly affect domestic interest
rates, weakening the control by the monetary authority.
As emerging markets yields tend to correlate, non-country
specific financial distress equally produces domestic turmoil
Investment funds tend to follow pro cyclical herding behaviors
in face of bad news
As a result, while domestic financial markets tend to channel
home-biased sources of funding in a stable fashion, their
development and increasingly global arbitrage might generate
some negative side-effects that may have consequences on
financial stability if not correctly addressed.
Some Financial Stability Implications
of Local Bond Markets
Mario Bergara
Central Bank of Uruguay
Conference on Global Finance in Transition
Istanbul, May 8, 2013