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Foreign Participation in Local-Currency Bond Markets

The analysis of local currency bond market development is of particular interest to both policymakers and investors. Countries that have less developed local currency bond markets and rely heavily on foreign currency bonds are more likely to suffer from a currency mismatch and are hence more susceptible to currency crises [Krugman (1999), Jeanne and Zettelmeyer (2002), Schneider and Tornell (2004), Aghion, Bacchetta and Banerjee (2004), Goldstein and Turner (2004)].

Deeper local bond markets can also provide a redundancy of funding sources, something that may well ameliorate financial crises [Greenspan (1999)]. An understanding of the factors associated with less developed bond markets could provide policymakers with a prescription for avoiding the financial fragility inherent in a currency mismatch.

Data limitations have, however, hampered empirical research on bonds. Unlike equities, information on bonds is not readily available across a wide range of countries, in part because bonds do not typically trade on standardized exchanges. Perhaps because of the relative paucity of bond market data, the literatures on financial development and international portfolio analysis have largely focused on equities.

In the financial development literature, for example, the debate on the relative merits of bank-based and market-based financial systems typically excludes bonds; because of data limitations, in that literature market-based refers to equity market development only (Levine, 2002; Ergungor, 2004). In the international portfolio literature, a limited discussion of international bond returns and the home bias is provided by Bekaert and Harvey (2003) and Tesar and Werner (1995).

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Foreign Participation in Local-Currency Bond Markets