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For emerging market governments, why is it safer to issue bonds in local currencies than in foreign currencies to raise money? Given that both are invested in by foreign investors, couldn't both potentially lead to exchange rate risk and currency fluctuations, say if there is a sell-off?

I was confused about this while reading 'Pragmatic Approaches to Capital Market Liberalization' (2008), a paper by Raghuram Rajan and Eswar Prasad. It comes up on page 13.

I tried looking at Investopedia and a Financial Times article on the topic of emerging market bonds, but they seemed to look at it from the perspective of investors and not public policy (I'm not suggesting its a tradeoff but maybe there's different perspectives, I thought).

https://www.investopedia.com/articles/03/073003.asp https://www.ft.com/content/56cb690e-c6a8-11e1-963a-00144feabdc0

Thank you for your help! I would really appreciate if to the extent possible, the answer is in layman(ish) terms.

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An EME's government collects taxes in domestic currency. If it issues debt in foreign currency and the domestic currency depreciates, the value of foreign currency-denominated debt increases. For example 1 000 000 000 USD is due at some date. If the exchange rate is 1 peso per dollar the government has to collect 1 000 000 000 pesos to pay it off. If the exchange rate becomes 1.25 pesos per dollar the domestc government has to collect 1 250 000 000 pesos. If the debt was denominated in pesos all along the government would still need only 1 000 000 000 pesos.

If debt to GDP is high such a depreciation may cause the EME government to default.

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  • $\begingroup$ Thank you! That makes sense. I was also wondering though, does the selling and buying of these bonds cause exchange rate risk (if they are in local currency)? Say if the local currency EME bonds are sold, and investors move their money to dollar bonds. Won't that still cause the local currency to depreciate and affect trade or any foreign currency debts held by the private sector? If the government is a significant debtor in the local economy, won't this create a lot more risk for the currency? $\endgroup$ – AlokR Aug 28 at 5:03

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