Andreas Dombret: Facing up to the original sin - experiences of
establishing a local currency bond market
Opening remarks by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the "Local Currency Bond Markets" Conference, Pretoria, 8 March 2018.
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1. Introduction
Dear Governor Lesetja Kganyago
Dear Deputy Governor Daniel Mminele
Ladies and gentlemen
I am very honoured to be here today at the Conference Centre of the South African Reserve
Bank (SARB) in Pretoria. This conference is another symbol for the close partnership between
the SARB and the Bundesbank. This partnership, together with our joint chairmanship of
the G20 Africa Advisory Group, gave the impetus for this event. The Africa Advisory Group
coordinates the G20"Compact with Africa" initiative that aims at promoting inclusive growth and
investment in Africa. I am convinced that this conference on local currency bond markets will
provide valuable insights on how the initiative's goals can be reached.
Let me start with a reminder of why we are all here today. True, we have come to talk about local
currency bond markets. But why are they important for a country's financial system?
Time and again, throughout the history of economic development, emerging economies have
given in to the temptation to over-borrow abroad, which often gives rise to a significant currency
mismatch on their aggregate balance sheets. Risky borrowing in foreign currencies can be
tempting because it is often cheaper than raising funds at home - last but not least as foreign
creditors accept lower interest rates when the exchange rate risk is born by the debtor. In blunt
terms, over-borrowing abroad is called the "original sin" of an emerging currency because -
although it comes at low cost in good times - it may cause serious damage to the economy
when there is an abrupt currency shift.
In contrast, the existence of a functioning local currency bond market can lower financing costs
at home and thereby provide the incentive to reduce foreign currency exposure. In the face of
volatile global capital flows, it can therefore help making emerging economies crisis-proof. What
is more, sound local currency bond markets support the development of a country's financial
sector and can channel foreign capital into an emerging economy, a valuable source of long-term
financing for both the government and the private sector.
Now, some of you may be thinking: Why is a German discussing these issues - given that
German sovereign bonds count internationally as "safe haven" investments and are traded on a
very deep and liquid market by international standards? To give you my short answer right away:
This hasn't been the case from the outset. In my speech, I would therefore like to draw upon the
German story 70 years ago in order to illustrate the lessons we have learned and to outline why
this conference may become a catalyst for local bond market development in developing and
emerging economies.
2. The German bond market - where it started in 1948
Let us travel roughly 70 years back in time.
At the end of World War II, Germany and its economy were devastated. Large parts of its
industrial plants and of its infrastructure lay in ruins - and so did its financial system. War
expenses had been financed via the printing press, and the German currency had lost its value.
It was only in 1948, when the Allied powers governing the country at that time initiated a
fundamental reform of the German currency, marking a turning point. The introduction of the
DMark and the foundation of a new central bank went hand in hand with the transformation of the
German economy from a centrally planned to a market-based system. This laid the foundation
for what is known as the "German economic miracle" of the 1950s and 60s.
And this is where local currency bond markets come into play. Their development in Germany
was already envisaged at the outset of economic policy reforms. But as you might suspect, the
German bond market, too, got off to a very bumpy start in 1948. The country and its currency
faced a lack of trust -and so did its bond market. People were very hesitant about saving
longterm, and many initial public offerings of bonds were disappointing. Just to give you an idea:
during the first 18 months of the D-Mark, only about half of all bond IPOs received funding on the
infant German capital market.
So we, too, have experienced that political will is one thing and implementation is another, and
that establishing a functioning bond market denominated in the local currency hinges on a
number of factors.
Let me now single out the aspects of bond market policies in Germany that I believe are still
instructive for today's policymakers.
3. The institutional framework
Again, let's zoom back to 1948. It quickly became clear that the undeveloped German bond
market needed two things: sound regulation and an independent central bank.
There is no question that regulation can be very useful in establishing certain financial
instruments and certain financial markets. For instance, when the German bond market was still
in its infancy, there was a law in place that required debt to be denominated in local currency
unless the central bank gave its special approval for foreign denomination. Undoubtedly, such
preferential legal treatment of bonds denominated in local currency was conducive to bond
market development and to the D-Mark becoming its nominal anchor. But, if not applied
prudently, regulation can also be a hindrance. Especially when it becomes too intrusive and
when it suspends the market mechanism. That is exactly what happened in Germany after the
1948 currency reform. Heavy price and interest rate controls were imposed on market forces
and put a serious drag on the emerging bond market.
Back then we also had to learn our lesson about implementing a sound regulatory regime; that it
needs to be a catalyst, not an impediment to the infant capital market.
But it turned out that regulation was not the only key to a successful currency and functioning
bond market in the emerging post-war economy in Germany. At least equally important was the
existence of an independent central bank that could credibly commit to its single mandate of
ensuring price stability. During the 1950s, such credible commitment to stable prices, combined
with sound fiscal policies, was instrumental in anchoring inflation expectations and in achieving
the kind of macroeconomic stabilisation that formed the foundation of the "economic miracle" I
just mentioned. And this also had a significant impact on investors' confidence in local currency
bond markets. In short: without a credible central bank, there is no stable currency. And without a
stable currency, there can be no thriving bond markets.
4. The central bank as a facilitator
Leaving institutional arrangements aside, which concrete positions can and should a central
bank take when it comes to shaping local currency bond markets? In other words, how should a
central bank act operationally? Well, during the second half of the last century, we at the German
central bank interpreted our role as that of a facilitator to the market.
There were three key aspects to this role. First, providing support to market participants. When
capital markets were liberalised in the mid-1950s, interest rate volatility surged. Consequently,
the German central bank promoted the foundation of a capital market commission, a discussion
platform, that consisted of the most important market participants. Its primary task was to align
the timing and volume of upcoming bond issuances with prevailing market conditions. In this
way, liquidity shortages and excessive price hikes on the market were to be prevented. As time
went by and bond markets got more mature, the cooperative work of the capital market
commission was replaced by yearly and quarterly issuance calendars for sovereign bonds.
A second aspect of the operational role of central banks concerns engaging in market
management. In terms of market management, the Bundesbank's strategy has always been
clear-cut. In 1957, the Bundesbank Law stipulated that the issuer of a bond is responsible for
market management and market smoothing operations. Indeed, the Bundesbank has since
conducted market management for federal government bonds; but we have done so on behalf of
the government, not on our own behalf. Let me stress here that the Bundesbank's approach is
just one of many, and that there is no right or wrong approach. This is only one way in which a
central bank is able to maintain independence and avoid fiscal dominance.
This brings me to the third aspect of the facilitation role that the German central bank opted for. In
the early stages of capital market development, market management of sovereign bonds can be
crucial for many reasons. One main reason is that financing conditions in most credit markets
critically depend - usually via price quotations - on the price that the sovereign has to pay for its
debt. In other words, a central bank's market management for government bonds can facilitate
the establishment of a benchmark debt yield curve. And a sound benchmark is key to a
functioning overall bond market.
That is how we did it. And there might be a lot of other ways of doing it. I want to emphasise
again, however, that when embarking on the development of domestic bond markets, every
central bank should be wary of trading its institutional independence for market involvement.
Because providing the sovereign with market management services always entails the potential
of exposing the central bank to unwanted fiscal pressures.
5. Conclusion
Ladies and gentlemen, what can the German experience teach us? First, it can teach us that the
political will to enhance local currency bond markets needs to be accompanied by a number of
supporting factors. A well-balanced regulatory regime and a stable currency - defended by an
independent central bank - certainly are among these factors.
Second, while I am convinced that regulation and central bank independence are universally
valid, the concrete strategy a country's central bank may follow in promoting local currency bond
markets is not. As every country finds itself confronted with unique challenges, the ways to tackle
them are unique as well. And though I hope you regard my anecdotes and remarks based on the
example of Germany as inspirational, every central bank has to find its own strategy.
In my speech, I have touched upon some of the topics of tomorrow's panel discussions, such as
market management, the benchmark yield curve and, in particular, the role of the central bank. I
am convinced that tomorrow's discussions will shed light on these and many other aspects of
bond market development.
I wish you all fruitful discussions and an inspiring conference.
Thank you to the South African Reserve Bank for hosting us and to you all for your attention.