What drives emerging market and developing economies’ local currency sovereign yields? A comparative approach

In recent years, benign global liquidity conditions and a low interest rate environment in advanced economies have contributed to increased interest among investors in emerging market sovereign debt markets. Local currency bond markets in emerging markets swelled in size following the global financial crisis, more than doubling in nominal terms between 2011 and 2018 (IMF and World Bank 2020).1 Understanding the factors that determine yields on marketable debt can help shape government policy in important ways, including making improvements to the way sovereign debt is issued and managed. A better functioning and more efficient sovereign debt market can, in turn, lead to lower cost of funding for the sovereign in the long run.

Methodological framework

Our recent paper describes a simple and flexible analytical framework for analyzing the determinants of local currency sovereign borrowing costs of a country relative to comparable peer countries.

The framework consists of quantitative empirical analysis and qualitative country case studies. The former allows for a quantitative comparison of a country’s sovereign yields with comparable countries in the context of a wide variety of different determinants (figure 1). We explore domestic macroeconomic and financial market factors, external factors, and other political and institutional factors. The latter case studies draw on the reform experiences of selected peer countries in developing their local currency sovereign debt market. The case studies complement the quantitative analysis by looking at important factors that are not easily captured in an empirical analysis for technical reasons.

In our empirical framework, we trace the evolution of excess yields the country of interest pays relative to peers as we consider different specifications/explanatory variables. A panel data set consisting of a reasonably long time-series for all relevant variables for the country of interest and a group of peer countries was assembled.

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However, a sizable share of variation in a country’s yields relative to peers may remain unexplained by the quantitative analysis. To address challenges in the domestic government bond market, several emerging markets have undertaken reforms to improve the functioning of their government bond market, aligned with international best practice. These policy experiences and lessons learned offer a variety of different potential policy paths and complement the paper’s empirical analysis.

Figure 1. Potential factors influencing sovereign yields in an emerging market economy

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