Local Currency Bond Market Development and Currency Stability amid Market Turmoil

LOCALCURRENCYBONDMARKETDEVELOPMENTANDCURRENCYSTABILITYAMIDMARKETTURMOIL CheonkooKim,DonghyunPark,JungsooPark,andShuTian NO.688 July2023 ADBECONOMICSWORKINGPAPERSERIES ASIANDEVELOPMENTBANK ADBEconomicsWorkingPaperSeries LocalCurrencyBondMarketDevelopmentandCurrencyStabilityamidMarketTurmoil CheonkooKim,DonghyunPark,JungsooPark,andShuTian TheADBEconomicsWorkingPaperSeriespresentsresearchinprogresstoelicitcommentsandencouragedebateondevelopmentissuesinAsiaandthePacific.TheviewsexpressedarethoseoftheauthorsanddonotnecessarilyreflecttheviewsandpoliciesofADBor itsBoardofGovernorsorthegovernmentstheyrepresent. No.688|July2023 CheonkooKim(ck1009@korcham.net)isaresearchfellowattheKoreaChamberofCommerceandIndustry.JungsooPark(jspark@sogang.ac.kr)is aprofessoratSogangUniversity.DonghyunPark(dpark@adb.org)isaneconomicadvisorandShuTian(stian@adb.org)isasenioreconomistattheEconomicResearchandDevelopmentImpactDepartment,AsianDevelopmentBank. ASIANDEVELOPMENTBANK CreativeCommonsAttribution3.0IGOlicense(CCBY3.0IGO) ©2023AsianDevelopmentBank 6ADBAvenue,MandaluyongCity,1550MetroManila,PhilippinesTel+63286324444;Fax+63286362444 www.adb.org Somerightsreserved.Publishedin2023. ISSN2313-6537(print),2313-6545(electronic)PublicationStockNo.WPS230228-2 DOI:http://dx.doi.org/10.22617/WPS230228-2 TheviewsexpressedinthispublicationarethoseoftheauthorsanddonotnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank(ADB)oritsBoardofGovernorsorthegovernmentstheyrepresent. ADBdoesnotguaranteetheaccuracyofthedataincludedinthispublicationandacceptsnoresponsibilityforanyconsequenceoftheiruse.ThementionofspecificcompaniesorproductsofmanufacturersdoesnotimplythattheyareendorsedorrecommendedbyADBinpreferencetoothersofasimilarnaturethatarenotmentioned. Bymakinganydesignationoforreferencetoaparticularterritoryorgeographicarea,orbyusingtheterm“country”inthispublication,ADBdoesnotintendtomakeanyjudgmentsastothelegalorotherstatusofanyterritoryorarea. ThispublicationisavailableundertheCreativeCommonsAttribution3.0IGOlicense(CCBY3.0IGO)https://creativecommons.org/licenses/by/3.0/igo/.Byusingthecontentofthispublication,youagreetobeboundbythetermsofthislicense.Forattribution,translations,adaptations,andpermissions,pleasereadtheprovisionsandtermsofuseathttps://www.adb.org/terms-use#openaccess. ThisCClicensedoesnotapplytonon-ADBcopyrightmaterialsinthispublication.Ifthematerialisattributedtoanothersource,pleasecontactthecopyrightownerorpublisherofthatsourceforpermissiontoreproduceit.ADBcannotbeheldliableforanyclaimsthatariseasaresultofyouruseofthematerial. Pleasecontactpubsmarketing@adb.orgifyouhavequestionsorcommentswithrespecttocontent,orifyouwishtoobtaincopyrightpermissionforyourintendedusethatdoesnotfallwithintheseterms,orforpermissiontousetheADBlogo. CorrigendatoADBpublicationsmaybefoundathttp://www.adb.org/publications/corrigenda.Notes: Inthispublication,“$”referstoUnitedStatesdollars. ADBrecognizes“Korea”astheRepublicofKorea. ABSTRACT Thisstudyinvestigateshowdevelopmentofthelocalcurrency(LCY)bondmarketbringsstabilityinthefinancialmarket.Theanalysisisbasedonannualeconomypaneldatasetfor1989–2020.Themainfindingsareasfollows.First,exchangeratevolatilityislowerduringcrisisperiodsifaneconomyhasamoredevelopedLCYbondmarket.Second,agreatershareofLCYbondsandagreatershareofbondswithlong-termmaturitieshaveastabilizingeffectonexchangeratevolatilityduringnormaltimes.Lastly,adevelopedLCYbondmarketcanserveasabufferagainstmonetarypolicyshocksemanatingfromtheUnitedStates.TheempiricalevidenceinthisstudyimpliesthatemergingeconomiesneedtoconsiderdesigningpoliciestobolsterdevelopmentofLCYbondmarkets. Keywords:localcurrencybondmarket,exchangeratevolatility,currencymismatch,maturitymismatch,financialcrisis JELcodes:E22,G31 1.Introduction In2022,acceleratedmonetarytighteningintheUnitedStates(US)ledtocurrencydepreciationandcapitaloutflowsinemergingmarkets.Thisagainhighlightsemergingmarkets'vulnerabilitytoglobalshocks:marketliquidityisnegativelyaffectedasinvestorssellriskyassetsandshiftfundstosafeandliquidassets,whichisknownasflight-to-qualityandflight-to-liquidity. Aliquidityshortage,combinedwithstructuralissuesinthemarket,couldleadtoasystemicfinancialcrisis.Forexample,inthelate1990s,maturityandcurrencymismatcheswerewidelydocumentedasakeystructuralissueinfinancialmarketsthatcontributedtothe1997/98Asianfinancialcrisis.EichengreenandHausman(1999)claimedthatemergingmarketsbecomevulnerabletoshocksbecausetheseeconomieshavedifficultyborrowingfromabroadintheirdomesticcurrencyandborrowinglongerterm.Tomitigatefinancialfragilityarisingfromtheseweaknesses,manyAsianeconomieshaveputeffortsintodevelopinglocalcurrency(LCY)bondmarketstochannelLCYfunding,especiallylonger-termtenors,toborrowers(Parketal.2019). ThisstudyaimstoevaluatehowmuchdevelopmentofLCYbondmarketscancontributetostrongerfinancialstability.Thespecificresearchquestionistofindoutwhethertheexchangeratevolatilityresponsestoglobalshocksaresignificantlysmallerforeconomieswithmoredevelopedlocalcurrencybondmarkets. A