Emerging market sovereigns have come out of the latest financial crisis looking like paragons of responsible borrowing, after learning to rely far less on external markets for funding in the wake of the emerging market debt crisis of the 1990s, which brought many countries to their knees.
Development banks helped them to create domestic capital markets and thereby become less exposed to currency fluctuations in the dollar or euro and leave assets and liabilities better matched. Also, if credit markets were to freeze, these countries would have an alternate source of funding, reducing refinancing risk.
The strategy seems to have paid off. More than £35bn flooded into emerging markets in 2010 as investors piled into countries with lower public debt ratios and less exposure to the volatile dollar and euro.
But developing domestic markets is still not easy. There are many challenges to overcome, not least macroeconomic stabilisation and the curbing of inflation.
"Thats a prerequisite in terms of having anything beyond a money market," says Phillip Anderson, senior manager and head of public debt advisory at the World Bank treasury in Washington.
Establishing a varied investor base can also be tough. When domestic markets first get going, it is only banks that tend to participate. The development of pension funds, mutual funds and insurance companies takes rather longer. And even for the banks, it is a challenge. Term deposits in local currencies can be retracted with little notice, which makes it hard for them to invest for longer periods. A central bank that is committed to being a lender of last resort can help smooth the path, according to the European Bank for Reconstruction and Development (EBRD).
Development banks say monetary policy implementation is also crucial. For markets to flourish, interest rates have to be allowed to fluctuate. Exchange rate policy is also important. For many international investors, a dollar currency peg makes it hard to see the value of investing in a domestic market. The stricter regulations and more straightforward processes of the international bond market are likely to win out.
Getting emerging market participants more used to the rules of engagement can be difficult, even after important infrastructure elements like payment and settlement systems or a central depository are in place. For governments used to tight central control, letting the market decide prices through auctions can be a shock to the system.
With the basics done, the development banks are taking their involvement up to the next level. In 2010, the EBRD, World Bank and IMF decided to become more engaged in the development of emerging market domestic capital markets. They chose five countries, which have not been disclosed, on which to focus their efforts.
The latest target countries were selected depending on where the development banks could most efficiently invest time and where market foundations would be most straightforward to build, say those involved in the process. The group is diverse and the countries are all at different stages.
"If its an early transition country, it may not be at the stage of developing a corporate bond market and it might need help with regards to monetary policy and inflation targeting," says Isabelle Laurent, deputy treasurer and head of funding at the EBRD in London. "If its at a later stage, it may need more guidance on how corporate bonds could develop.
For Laurent, the new initiative is about working out the order in which to target different reforms that will help build domestic capital markets.
Progress on the latest initiative will be presented at the EBRDs meeting in Astana, Kazakhstan, in May. Another four or five countries will then be chosen for similar treatment in 2012.
After a domestic market is established, development banks aim to issue bonds in it, often becoming its first international borrower. This raises international awareness and creates a more diverse market.
The EBRD issued domestic Hungarian forint bonds in 1994 and 1996, and launched domestic Russian rouble bond issues in 2005, 2006, 2009 and 2010. The World Bank was the first foreign issuer in Uruguayan peso bonds in 2008, Romanian leu in 2006 and Chilean and Mexican pesos in 2000.
"We have anecdotal evidence of investors that have come into a local bond market for the first time because theyve been attracted by a World Bank issue in that market, then staying in that market to buy a local government security and then following on from that perhaps by buying a local corporate bond," says Michael Bennett, lead financial officer, capital markets, at the World Bank treasury in Washington.
In addition, for a domestic issue, development banks typically mandate one local and one international bank, in the hope that they share knowledge.
"Theres a lot of capacity for knowledge transfer from the international bank to the local bank in terms of how to do a bond issue for an international issuer," says Bennett.
The prestige in being the first to issue is great, but it is often a reflection of years spent helping the development of that market. But the work does not stop there. Repeat issuance and encouraging others to borrow is the key to establishing an active secondary market.
"Once a domestic market has been opened and one supranational has issued in that market, its not a complete process," said Laurent. "There needs to be a host of supranational, bank and corporate issuers to make a market. Being the first is not the prize, as the real goal is to have a fully functioning market. A one-off transaction rarely does what youve set out to do."
The development banks, true to the mantra of creating a fully functioning market, will only issue in a domestic market if the funding level available is comparable with other sources of funding. But the currency risk is often not kept by the development banks, who swap the currency back to their funding currency if a swap market exists, or lend the money to a project requiring funding in that currency.
"When technically and economically feasible, we swap the borrowings back to floating-rate dollars for IFCs matched funded dollar book," says Nina Shapiro, who retired on March 1 as treasurer and vice president of finance at IFC in Washington. "This then also allows lending that caters to the client interest. If swaps are not possible, then the proceeds are on lent to a particular investment. There is a preference not to do the latter as it imposes the terms of the bond on to our clients."
According to Laurent, the EBRD looks at where it plans to lend when targeting markets for issuance, to reduce currency risks for the recipient of its funds.
The focus of the development banks on developing local capital markets does not preclude them from also encouraging emerging market countries to participate in the international capital markets, albeit moderately.
"The important thing is to get a balance," said the World Banks Anderson. "While some degree of capital inflows is a positive thing and supportive of local currency markets, you can have too much of a good thing."
The development banks treasuries can offer advisory services to client countries on tapping international markets, but these deals are often left to international investment banks.
The World Bank has, however, set up an innovative fund to help Gabon manage a buyback of its dollar bond. Gabon now sets aside money each year into a trust fund managed by the World Bank. The Bank then invests that money for Gabon, which can be used to repay the bond upon maturity. In the meantime, the Bank can execute buyback transactions to help support the bonds liquidity in the secondary market.
"This role is quite new for us," says Heike Reichelt, head of investor relations and new products at the World Bank in Washington. "Its one of the services we recently started offering clients. If it fits in with how a government would like to manage its debt and with the World Banks overall work with the client, we can provide this service."
Worth the effort
Overcoming the difficulties inherent in creating a new domestic market is clearly worth the effort. The strong outcome for emerging markets in the latest financial crisis is testimony to the hard work put in by development banks and some emerging market economies to create these domestic markets. Russia, for example, relied heavily on its domestic rouble bond market when the availability of international credit froze in 2007. That domestic market had been a particular project of the EBRD.
"During the recent credit crisis, many EM countries were in a better fiscal and regulatory position than previously, says Shapiro. "The banks balance sheets were also not overextended, with a more moderate exposure to external debt. Therefore the EM as a group bounced back faster than the West. Helping to develop the local bond markets has been one of the beneficial factors."For leading emerging market names, much of the hard work has been done. Progress is far from uniform across the globe, but the successes of the last few years point the way for others searching for stability and growth.