# **1. Introduction**

The sovereign borrowing landscape in emerging market economies (EMs) is evolving rapidly. A notable trend in recent years has been the growth of local currency—as opposed to foreign currency—sovereign bond markets, enabling more developing country governments to meet an increasing proportion of their borrowing requirements by issuing securities domestically, in their own currencies. This success is attributable partly to improved macroeconomic fundamentals in emerging markets (lowering inflation risk premia enough to make longer-term borrowing in local currency feasible), and partly to the rise of domestic market participants with an appetite for longer-term lending (especially domestic pension and insurance companies).

These changes are well-known.<sup>1</sup> But one increasingly important source of demand for local currency sovereign bonds in EMs is more of an unknown quantity: foreign investors. This note explores this investor base, aiming to highlight salient aspects for EM government debt managers as they pursue their mandates. We briefly summarize recent trends, starting with the overall growth in EM local currency bond markets, followed by the extent to which foreign investor participation in these markets has risen. We then examine what the relevant academic literature can tell us about how offshore demand affects bond markets, before taking a more detailed look at the evolving sources of foreign demand and whether these are likely to be sustained. The note concludes with a discussion of considerations for EM debt managers based on our exploration of this topic.

The scope of this note is limited to describing and discussing some of the implications of increasing foreign investor activity in EM local currency bond markets, with the aim of providing a useful discussion for EM debt managers. We only touch on the much broader issue of managing portfolio investment as a whole, an area which is the subject of an ongoing debate with macroeconomic, fiscal, monetary and prudential policy implications that go well beyond the remit of public debt management.

A preview of this note’s central conclusions is as follows:

- The trend of rising foreign investor participation in EM domestic bond markets was in place before the global financial crisis and has since accelerated, with foreign ownership levels now at historic highs in several EMs.

- High-level categorizations of “foreign investors” and “EMs” risk being misleading. The class of “foreign investors” includes a broad range of investor types, while EMs encompass countries across a spectrum of economic and market size and development. Therefore, for the purposes of debt management, a more detailed categorization of foreign investor types is needed, and the impact of, and appropriate debt management responses to, foreign participation may differ significantly across countries.

- There is a lot that debt managers can do should they wish to encourage foreign investor demand. Many of the measures that might be considered are compatible with broader market development goals, including benchmark-building, the adoption of a consistent and transparent issuance strategy, and active management of investor relations and market communication. Benchmark bond index inclusion may motivate taking additional, specific measures.

- Improving market monitoring in order to maximize debt managers’ knowledge of foreign investors’ participation in their debt markets is a priority, given the significant odds that offshore demand for EM debt will prove to be sustained. In many countries which are witnessing more foreign investor participation, there is an urgent need for accurate, detailed and up to date holdings data.

> 1 For a good overview through 2005 see IMF, _Structural Changes in Emerging Sovereign Debt and Implications for Financial_ Stability, Ch. 3 of the _Global Financial Stability Report_ (April 2006). A more up to date treatment is Burger et al (2010).

**2**