Andreas Dombret: Local currency bond markets and international capital
flows
Introductory statement by Dr Andreas Dombret, Member of the Executive Board of the
Deutsche Bundesbank, at the third international workshop on developing local currency bond
markets in emerging market economies and developing countries, co-hosted with the World
Bank Group and the International Monetary Fund, Frankfurt am Main, 17-18 November 2011.
* * *
Ladies and gentlemen
Although the topic "Developing local currency bond markets in emerging market economies
and developing countries" rarely makes the headlines, it has rightly met with growing and
broader political support in recent years. This is a reflection of the great significance that
domestic bond markets in this region have for national and global financial stability. For this
reason, we are very pleased that this topic has been one of the main agenda items during
the French G20 presidency in 2011.
What is more, this lends greater continuity to the G20 process and to the discussion of the
G20 topics. Besides ensuring that summit decisions are implemented, this also gives these
decisions greater public credibility.
This applies, in particular, to the establishment or expansion of financial markets, which will
take decades rather than just a few years. Since the Asian crisis, many EMEs - supported by
numerous global, regional or national institutions - have been successful in their efforts to
deepen their local bond markets. Nonetheless, further challenges lie ahead.
At the global level, the G7 finance ministers and central bank governors agreed in 2007 that
developing local currency bond markets (LCBMs) deserved more political support. The
Bundesbank backed this process in close cooperation with the Federal Ministry of Finance
and played a major part in drawing up the G8 action plan, which was endorsed in May 2007.
Since then, the Bundesbank has, with the International Monetary Fund and the World Bank
Group, co-hosted three international workshops dealing with ways to implement the G8, and
now the G20, recommendations. And in the years ahead we will continue to play an active
role in this initiative in very fruitful and constructive cooperation with all of you.
The significance attributed to LCBMs for national and global financial stability is also
reflected in the fact that, as part of the G20 process, this topic was - inter alia - dealt with by
the International Monetary System (IMS) working group. A report on their findings was
submitted to the G20 finance ministers and central bank governors; this topic was also on the
agenda of the heads of state or government at the Cannes Summit 2011. In this context the
main focus has been put on the relationship between developed LCBMs and the volatility of
international capital flows, which is also the theme of today's workshop.
Against this background, I would like to focus on the following points:
 Objectives of the initiative and the contribution by the LCBMs to increasing financial
stability
 State of development of LCBMs
 Main challenges ahead
Objectives of the initiative
The main objective of the initiative was and is to strengthen national and global financial
stability. It is important to stress this. The development of LCBMs enhances the resilience of
the national financial systems and, therefore, global financial stability. In addition, a number
of developing countries have set themselves the task of attracting long-term global
investment capital to finance infrastructure investment and, in this way, to boost growth. But
very rightly, the G20 action plan points out that
"Future activities should ... bolster the role that LCBMs can play in improving
domestic and global financial stability and strengthening the ability of economies
to manage capital flows, thereby contributing to international monetary stability
more generally."
Merely stating that developing these markets can have a stabilising effect does not tell us
how to get there, nor what form the relevant process might take. In my view, there is a clear
need to step up research and expand the necessary data base. Useful though it may be to
acquire data by conducting surveys at intervals of five, seven or ten years, this process is
inadequate and hardly acceptable.
Yet we must be just as frank when considering the risks entailed in developing local bond
markets. After all, they are an important playing field for short-term portfolio inflows and
outflows. Indeed, this is true of the present capital inflows to the EMEs: short-term portfolio
investment represents no less than 50% of capital inflows.
As far as potential contributions by LCBMs to financial stability are concerned, I would like to
mention just a few which have proven important, not least in the context of the current
financial crisis.
 Deeper LCBMs reduce the vulnerability of the relevant EMEs to fluctuating interest
rates and exchange rates. The main reason for this is that LCBMs help reduce
currency and maturity mismatches, which trigger and amplify crises. Thus, they help
check contagion and prevent spillovers to the real economy.
 LCBMs make the financial system more diversified, and make it easier for
enterprises to access finance on international credit markets in times of tension.
What is more, they play a part in ensuring that savings are not invested solely or
primarily in equity markets, which could promote herd behaviour.
 LCBMs facilitate the smooth market-based financing of investment needs.
 First studies, which require substantiation, back up the assumption that developed
LCBMs also help dampen the volatility of international capital flows, a finding of
major significance in the light, in particular, of this year's G20 discussion.
 They broaden the spectrum of investments for international investors and facilitate
their global search for diversification.
 According to some commentators, LCBMs actually contribute to rebalancing by
keeping savings at home. These savings not only boost domestic investment and
consumption, they also increase the country's propensity to import.
This is only an abbreviated list of the potential advantages identified during the financial
crisis, although some of them are as yet no more than a scientific working hypothesis.
Analyses of this kind always beg the question of their practical implications for any
amendments to concepts for technical assistance that may be necessary or changes to
priorities. This workshop can bring us an important step forward by also helping to formulate
key questions for further research.
Some key questions concern technical assistance itself, however, and are related more to
the structure and state of development of the relevant countries than the question of financial
stability itself. The focus of the workshop is quite rightly on discussing and developing a
diagnostic framework, the aim being to categorise countries by their state of development
and financial structure and to determine what TA measures promise the greatest success in
which countries.
Although many institutions are working on these issues, permit me to make particular
mention of the European Bank for Reconstruction and Development (EBRD). The EBRD is
incorporating into this workshop major elements of its local bond initiative, which has been
well received worldwide.
To develop a framework that defines uniform principles for all countries is a real challenge,
yet it is crucial as a means of heightening the efficient deployment of TA resources.
The question of what obstacles lie on the path to deeper LCBMs is not just about regulatory
roadblocks or market infrastructure - which are among the usual suspects when evaluating
such things. No, it is important to see local bond markets not only in isolation but also within
the overall context of the financial system. For example, a financial system with a
decentralised banking sector might fully meet the financial needs of a decentralised
economic structure and do so with minimum transaction and opportunity costs. Given such
interdependence, it would make no sense to develop bond markets that go against market
economy incentives. A diagnostic framework needs to be placed in this broad context if it is
ultimately to produce the desired results.
State of development
LCBMs have developed rapidly in recent years. The domestic debt outstanding in emerging
market economies amounts to US$9.2 trillion (end of March 2011). It has more than doubled
since March 2006, and this dynamic growth has not been much influenced by the financial
crisis. LCBMs have significantly more potential. Just for illustration: while the EMEs have a
share of around 34% of world GDP, the weight of debt securities is only 91⁄2%. Moreover, this
development must not blind us to the fact that important challenges lie ahead and - to put it
in a nutshell - that they lie in the very areas that bring to bear the advantages of LCBMs,
which I have just mentioned. I would like to raise just a few here:
 Above all, let me say that in many countries corporate bond markets either do not
exist or are under-developed. However, only if there is sufficient liquidity on these
markets can they serve as a spare tyre when other sources of funding dry up.
Sovereign bonds account for two-thirds of bond markets; corporates for only
one-eighth.
 There is also a great deal of concentration in EM regions, with two-thirds accounted
for by EM Asia and only around 8% by EM Europe.
 Moreover, outstanding local currency bonds of EMEs are concentrated on just a few
countries. Five countries (China, Brazil, South Korea, India and Mexico) account for
around three-quarters of overall market volume. Of those, China is the biggest
market with more than one-third.
 But - and this is a next point - strong growth momentum is not always
predominantly driven by market forces. For instance, in order to sterilise the liquidity
effects of its foreign exchange market intervention, the People's Bank of China also
issues short-term paper on LCBMs. Statistically, these short-term notes count as
local bonds. Nevertheless, these markets offer a platform through which both
monetary and fiscal management can be facilitated in times of crisis.
Main challenges ahead
These arguments regarding the state of development lead us to other major challenges.
First, if one main objective of this initiative is to strengthen the liquidity of those markets, the
financial crisis in particular has shown that there is a lack of liquidity in times of tensions
because withdrawals of liquidity by foreign investors are not sufficiently replaced by domestic
investment in this country group.
A second aspect that calls for clarification and is important not only for LCBMs when
assessing financial stability is that liquidity was often withdrawn without any great distinctions
being made in terms of fundamentals and macroeconomic stability, meaning that open and
developed markets can also jeopardise countries that are highly stability-oriented. We
therefore also need to be mindful of the extent to which LCBMs not only increase the stability
of the international monetary system but also contribute to changing the global financial
transmission mechanism.
Broadening the data base remains one of the top priorities. Closing data gaps should be a
very targeted and cost-effective process. For example, data that have been available only in
the form of irregular surveys should be translated into regular, more timely and internationally
consistent statistics. The broader support of the G20 can give these data initiatives a
significant impulse, in particular in EMEs. But before raising new statistics, we should first
and foremost check whether existing tools can be used to filter out data of relevance to
LCBMs. The Bundesbank's flexible multi-dimensional approach for providing user targeted
data on German securities holdings statistics, which currently covers comprehensive
microdata for more than a million different securities, is just one example.
Although the budget constraints for EMEs expand as they become more integrated into the
global savings markets through more developed domestic bond markets, there is no
alternative to a credible fiscal consolidation strategy. Moreover, it is especially important to
prevent a high concentration of sovereign bonds from building up at banks, and to examine
whether and to what extent a concentration of this kind may even actually be encouraged by
regulation in some EMEs.
In sum and without any doubt, LCBMs can significantly help to manage the volatility of
international capital flows.