Limited Participation and Local Currency Sovereign Debt
MARCH 6, 2019 13:15-14:30
Abstract: Emerging country governments are increasingly issuing bonds denominated in local currency and foreign investors’ share in these markets, though once negligible, has been progressively growing. This growth has accelerated after the global financial crisis. This paper presents a model of segmented markets, in which specialized foreign investors can access multiple local markets only after paying an entry cost. In the model we show that when the US risk-free rate is sufficiently low, the benefits of investing in new markets are greater than the entry costs. When we then feed in actual U.S. interest rate data after the Great Recession, the model predicts a strong increase in the fraction of local currency debt held by foreign investors, higher comovement of asset prices and lower gains from diversification.