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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

a sharp recovery in both funding costs (October 2020 Global Financial Stability Report ) and portfolio flows (see Goel 2021 for a recent update on emerging market capital flows) Since then, the recovery has been uneven between local currency and hard currency debt assets . Local currency bond yields have risen rapidly in 2021, despite the decline in US Treasury yields and are now higher than their pre-pandemic level (as of the end of 2019). This contrasts with the significant decline in hard currency bond yields (and spreads) and subsequent stability

Mr. Evan Papageorgiou and Rohit Goel

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

International Monetary Fund. Monetary and Capital Markets Department

financial conditions . External Factors Have Been the Dominant Drivers of Portfolio Flows Lower rates and positive investor sentiment have supported asset prices and portfolio flows to emerging and frontier markets in 2019. Debt portfolio inflows rebounded for most of this year, led by strong inflows into hard currency bond markets ( Figure 4.1 , panels 1 and 2). Market pressures in Argentina have not led to notable spillovers to other lower-rated countries so far ( Figure 4.1 , panel 3), likely due to the small weight of Argentine bonds in the benchmark bond

Fabio Cortes and Luca Sanfilippo

currency, local currency bond, and hard currency bond markets. The results are summarized in three main regressions, where the dependent variable in each regression is defined as a performance spread over the respective emerging market benchmark—see Annex 1 for further detail on the regression analysis and methodology. For currencies, this translates into the performance spread of the local currency over the J.P. Morgan Emerging Market Currency Index. For local currency bonds, it reflects performance relative to the J.P. Morgan GBI Diversified Index, and for hard

Fabio Cortes and Luca Sanfilippo
Unconstrained multi-sector bond funds (MSBFs) can be a source of spillovers to emerging markets and potentially exert a sizable impact on cross-border flows. MSBFs have grown their investment in emerging markets in recent years and are highly concentrated—both in their positions and their decision-making. They typically also exhibit opportunistic behavior much more so than other investment funds. Theoretically, their size, multisector mandate, and unconstrained nature allows MSBFs to be a source of financial stability in periods of wide-spread market turmoil while others sell at fire-sale prices. However, this note, building on the analysis of Cortes and Sanfilippo (2020) and incorporating data around the COVID-19 crisis, finds that MSBFs could have contributed to increase market stress in selected emerging markets. When faced with large investor redemptions during the crisis, our sample of MSBFs chose to rebalance their portfolios in a concentrated manner, raising a large proportion of cash in a few specific local currency bond markets. This may have contributed to exacerbating the relative underperformance of these local currency bond markets to broader emerging market indices.
Fabio Cortes and Luca Sanfilippo

shows a negative relation between changes in MSBF holdings and hard currency bond performance. This suggests that, in a period of outflows (DRA=0), an increase of MSBF inflows in an emerging country allocation of 1 percent is associated with underperformance over the emerging market EMBIG benchmark by –0.78 percent (vs. +0.17 percent in C&S). In a period of inflows (DRA=1), this impact is moderated to –0.06 percent (vs. +0.02 percent in C&S). The opposing developments in local currency versus hard currency flows, and the proposed explanation are in line with the

International Monetary Fund. Monetary and Capital Markets Department

at the time of the global financial crisis and 20 percent during the Asian financial crisis ( Figure 3.8 , panels 1 and 2). This convergence has been driven by a worsening of local currency ratings. 21 There are also notable differences between hard and local currency debt in terms of drivers of their valuations. 22 Hard currency bond spreads, especially for high-yield issuers, are affected about 60 percent more by global risk aversion shocks ( Figure 3.9 , panel 1). Local currency spreads are more sensitive to domestic vulnerabilities, including external debt

Mr. Luis Brandao Marques, Mr. R. G Gelos, Hibiki Ichiue, and Ms. Hiroko Oura
An analysis of mutual-fund-level flow data into EM bond and equity markets confirms that different types of funds behave differently. Bond funds are more sensitive to global factors and engage more in return chasing than equity funds. Flows from retail, open-end, and offshore funds are more volatile. Global funds are more stable in their EM investments than “dedicated” EM funds. Differences in the stability of flows from ultimate investors play a key role in explaining these patterns. The changing mix of global investors over the past 15 year has probably made portfolio flows to EMs more sensitive to global financial conditions.
Mr. Luis Brandao Marques, Mr. R. G Gelos, Hibiki Ichiue, and Ms. Hiroko Oura