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Mr. Evan Papageorgiou and Rohit Goel
An interesting disconnect has taken shape between local currency- and hard currency-denominated bonds in emerging markets with respect to their portfolio flows and prices since the start of the recovery from the COVID-19 pandemic. Emerging market assets have recovered sharply from the COVID-19 sell-off in 2020, but the post-pandemic recovery in 2021 has been highly uneven. This note seeks to answer why. Yields of local currency-denominated bonds have risen faster and are approaching their pandemic highs, while hard currency bond yields are still near their post-pandemic lows. Portfolio flows to local currency debt have similarly lagged flows to hard currency bonds. This disconnect is closely linked to the external environment and fiscal and inflationary pressures. Its evolution remains a key consideration for policymakers and investors, since local markets are the main source of funding for emerging markets. This note draws from the methodology developed in earlier Global Financial Stability Reports on fundamentals-based asset valuation models for funding costs and forecasting models for capital flows (using the at-risk framework). The results are consistent across models, indicating that local currency assets are significantly more sensitive to domestic fundamentals while hard currency assets are dependent on the external risk sentiment to a greater extent. This suggests that the post-pandemic, stressed domestic fundamentals have weighed on local currency bonds, partially offsetting the boost from supportive global risk sentiment. The analysis also highlights the risks emerging markets face from an asynchronous recovery and weak domestic fundamentals.
Mr. Evan Papageorgiou and Rohit Goel

An interesting disconnect has taken shape between local currency- and hard currency-denominated bonds in emerging markets with respect to their portfolio flows and prices since the start of the recovery from the COVID-19 pandemic. Emerging market assets have recovered sharply from the COVID-19 sell-off in 2020, but the post-pandemic recovery in 2021 has been highly uneven. This note seeks to answer why. Yields of local currency-denominated bonds have risen faster and are approaching their pandemic highs, while hard currency bond yields are still near their post-pandemic lows. Portfolio flows to local currency debt have similarly lagged flows to hard currency bonds. This disconnect is closely linked to the external environment and fiscal and inflationary pressures. Its evolution remains a key consideration for policymakers and investors, since local markets are the main source of funding for emerging markets. This note draws from the methodology developed in earlier Global Financial Stability Reports on fundamentals-based asset valuation models for funding costs and forecasting models for capital flows (using the at-risk framework). The results are consistent across models, indicating that local currency assets are significantly more sensitive to domestic fundamentals while hard currency assets are dependent on the external risk sentiment to a greater extent. This suggests that the post-pandemic, stressed domestic fundamentals have weighed on local currency bonds, partially offsetting the boost from supportive global risk sentiment. The analysis also highlights the risks emerging markets face from an asynchronous recovery and weak domestic fundamentals.

Mr. Evan Papageorgiou and Rohit Goel

key consideration for policymakers and investors, since local markets are the main source of funding for emerging markets. This note draws from the methodology developed in earlier Global Financial Stability Reports on fundamentals-based asset valuation models for funding costs and forecasting models for capital flows (using the at-risk framework). The results are consistent across models, indicating that local currency assets are significantly more sensitive to domestic fundamentals while hard currency assets are dependent on the external risk sentiment to a

International Monetary Fund

foreign exchange in Uzbekistan. Since early 1998, an enterprise is allowed to use its foreign exchange earnings (after the 30 percent surrender requirement) to pay for imports or other obligations abroad. In addition, an illegal curb exchange market operates in both cash and noncash. The latter is used to make payments abroad through the transfer of sum-denominated domestic bank balances, in exchange for a corresponding transfer of hard currency assets held abroad. Transactions in the curb market are typically those needed to satisfy imports not covered by licenses, as

International Monetary Fund

collateralized future receipt agreements in making financing decisions under Article V. See IMF (2003) , p. 14. 132 Tran and Roldos (2003) outline a broader set of policy actions and reforms for securitization. Although these recommendations are for securitization of existing (and local currency) assets such as mortgage loans, they also apply for securitization of future flow (and hard currency) assets.

Mr. Brad Setser, Nouriel Roubini, Mr. Christian Keller, Mr. Mark Allen, and Mr. Christoph B. Rosenberg
The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.
Mr. Brad Setser, Nouriel Roubini, Mr. Christian Keller, Mr. Mark Allen, and Mr. Christoph B. Rosenberg

increased solvency risk and led to default in Russia and Argentina. Box 2. How Balance Sheet Risks Apply to Different Sectors Risk Sector Maturity Mismatch Currency Mismatch Capital Structure Mismatch Solvency (Liabilities v. Assets) Government Government’s short-term hard currency debt (domestic and external) v. government’s liquid assets(reserves)* Government’s debt denominated in foreign currency (domestic and external) v. government’s hard currency assets (reserves) N/A Liabilities of government and central bank v

Fabio Cortes and Luca Sanfilippo
Emerging economies in the post-crisis period increasingly saw portfolio debt inflows from a type of large international investment fund: Multi-Sector Bond Funds (MSBFs). These investors have lacked adequate representation in the literature. This paper constructs a new detailed database from micro-level MSBF emerging market (EM) holdings from 2009:Q4–2018:Q2. Exploiting this data, the paper assesses the risks they pose to the financial stability of specific emerging bond markets. The data shows that MSBFs are highly concentrated–both in their positions and their decision-making. The empirical results further suggest that MSBFs exhibit opportunistic behavior (and more so than other investment funds). In periods of high risk aversion, large MSBF portfolio reallocations out of EMs can be associated with underperformance of the same markets, signaling the importance of monitoring their footprint and better understanding their asset allocation decisions.
International Monetary Fund. Middle East and Central Asia Dept.

prior to the creation of the KIA by the London-based Kuwait Investment Office. The GRF is the repository of the annual state’s revenues, the accumulated past surpluses, and retained investment income. Budget expenditures are paid out of the GRF as stated in the budget law. The GRF consists of investments in Kuwait and other MENA countries as well as hard currency assets held by KIA on behalf of the State of Kuwait. The GRF also holds other government assets, including Kuwait’s participation in public enterprises such as the Kuwait Fund for Arab Economic Development

International Monetary Fund

risk-adjusted return of their fixed income portfolios due to diversification benefits. Large global mutual funds, sovereign wealth funds, and reinsurers would fall in this category. They may have stronger appetite for exposure to smaller economies whose macroeconomic fundamentals (and therefore the state variable) are weakly correlated to returns in major AE markets, although investment mandates may limit investments in sub-investment grade or non-hard currency assets. Some of these investors may also be relatively protected from liquidity risk and thus be candidates