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Fickle emerging market flows, stable euros, and the dollar risk factor

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Policymakers fear volatile global investors are upsetting emerging markets. John Burger notes that Euro area investors are volatile in emerging bond markets but do not surge and flee.

Image courtesy of interviewee. February 1, 2024

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This video video text summarizes a research study jointly conducted by the speaker and Martin Bormans from the Dutch Central Bank, published in the Journal of International Economics. The study focuses on the investment behavior of European investors in emerging market economies, particularly around the "risk on, risk off" cycles characterized by fluctuations in investor sentiment toward riskier assets.

Key points include:

1. **Risk Cycles and Emerging Markets**: The paper discusses how investors fluctuate between risky and safe assets, heavily impacting emerging market economies, which are particularly vulnerable to such cycles.

2. **Data and Analysis**: The authors utilize detailed granular data from the European Central Bank to analyze investor behavior, specifically focusing on bond holdings in different currencies (Euros, Dollars, and local currencies).

3. **Investor Behavior**: The study finds that European investors exhibit a strong "home currency bias," preferring Euro-denominated bonds, which show stable inflows regardless of global market conditions. Conversely, flows into local currency and dollar-denominated bonds are volatile and influenced by various risk factors.

4. **Currency and Risk Factors**: The analysis highlights that currency fluctuations significantly affect investor behavior. Investments in local currency bonds tend to decline during periods of currency depreciation, while dollar-denominated bonds are sold off due to concerns about borrowers' balance sheet risks, especially when countries have large foreign currency debts.

5. **Response to Economic Shocks**: The research includes case studies highlighting investor responses to economic shocks, such as the COVID-19 pandemic and the Federal Reserve's interest rate hikes, with findings showing that investors differentiate between assets based on their currency risk and the creditworthiness of the issuers.

6. **Insights and Implications**: The study concludes that understanding investor behavior during risk cycles requires looking beyond aggregate flows to consider how specific risks—including currency mismatch risks and overall credit quality—affect investment decisions. Emerging market borrowers are advised to be cautious about debt in foreign currencies and consider issuing bonds in multiple currencies to appeal to European investors.

Overall, the research provides new insights into the dynamics of investment in emerging markets, emphasizing the importance of currency denomination and risks associated with borrowing in foreign currencies.

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X-TIMESTAMP-MAP:LOCAL=00:00:00.000,MPEGTS=900000

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The paper is, first of all,

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I wanna acknowledge this joint work with Martin Bormans

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of the Dutch, central Bank,

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and the has been published in the Journal

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of International Economics.

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The context, for our study is that there is

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a, a risk on risk off cycle

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that investors tend to go through.

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And, and you read about that in the financial press,

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but there's also an extensive academic literature exploring

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this tendency of investors to sometimes rush into,

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riskier assets and then other times sort of pull back

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or we say retrench into safe assets.

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Uh, and this fickleness of,

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of global investors is particularly important

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for emerging markets.

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And hence, we focus our analysis on

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emerging market economies.

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And they're vulnerable to this, this

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inflow outflow global cycle,

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because they may, during the good times get used

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to being able to borrow at relatively low rates and,

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and it will help, stimulate their economies.

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But then, when a bump comes in the road

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and investors pull out, that could be quite disruptive.

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Now, this is, this is all well documented.

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Um, our angle is that we have access

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to very detailed granular data,

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and that enables us to look a little deeper

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and say, okay, investors have this risk on risk off cycle,

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but what risks specifically are investors worried about?

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And what is it that triggers these, on off episodes, one

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of the branches of the literature has recently focused on

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the broad US dollar as a barometer of risk appetite

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for global investors.

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Okay? And the, the, sometimes this is linked also

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to federal reserve policy.

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So you can imagine periods when the Federal Reserve is

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raising interest rates,

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and the dollar tends to get stronger.

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The literature shows that those periods are, when

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we see this risk off, attitude that,

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investors will sell risky assets including emerging market

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assets, and they'll retrench to safe assets, including,

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the US Treasury as, as one predominant,

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global safe assets.

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And then other periods when you see,

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interest rates falling and the Fed being more expansionary

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and the dollar tending to depreciate, that triggers the,

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the risk on periods.

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Okay? So the do the broad dollar has become an indicator

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for the risk cycle.

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Most of the analysis is rather US-centric,

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or again, the dollar being the dominant currency.

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The US investors get a lot of attention.

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Uh, so we add another dimension

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by looking at it from the European perspective.

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And so we're able to see, well, is this broad dollar,

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also important for European investors?

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Uh, and then we're also adding another dimension

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because we're able

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to bring a third currency into the analysis.

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So rather than just looking at dollar denominated assets

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and local emerging market denominated assets,

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what about the Euro denominated assets?

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What role do they play in this sort of triangulation

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that we're able to, to do?

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And that's important,

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because if you don't have,

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if you just look at dollars versus local currency, it's hard

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to tease out how much of this is flight

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to the global safe currency, versus just coming

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to a home currency.

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And so with the European perspective,

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now you have three dimensions.

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You have a home currency, which is the Euro.

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You have the global safe currency, the dollar,

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and then the local currency in emerging markets.

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So that allows us to take a different angle

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and get new perspectives.

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Uh, one additional branch of the literature that's,

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associated with our study would be the

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borrower perspective.

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So the borrowers, we know

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that there's an extensive literature saying

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that when emerging markets borrow in foreign currency,

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that introduces risk to their balance sheet.

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So they're borrowing in one currency,

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but they may have revenue in their own local currency,

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and that's called a currency mismatch.

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Uh, and those are risks

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that we know have caused crises in the past.

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In emerging markets, we're mostly focused

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on the investor perspective.

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So we're wondering, do investors pay attention

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to those risks, and are they specifically attuned to which

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emerging market borrowers have those mismatches?

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We are very fortunate in this paper

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to have an outstanding data set, a very detailed

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granular data set provided by the European Central Bank,

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and it has security level holdings by Euro area investors

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of financial assets we're focused on, again,

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on emerging markets,

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and we're focused on emerging market bonds.

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And this detailed data set tells us which bonds,

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Euro area investors are whi which bonds are held

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by Euro area investors, and

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how those holdings change over time.

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Uh, so we start with a descriptive look at this data,

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and we established that ary investors, first of all,

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they are very significant holders of these bonds.

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So we find that in many cases,

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ary investors hold over 10% of the amounts outstanding.

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But that's a significant share of the bonds issued by these

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corporates and sovereigns, in emerging economies.

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And then, the currency dimension that I had mentioned

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before, that three-way currency dimension, if you look,

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look, look at just the raw data.

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We see that European investors, roughly speaking, have a

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three-way split.

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About one third of their bonds,

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that they hold are denominated in the

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local emerging market currencies.

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About one third are dollar denominated,

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and the last third are Euro denominated.

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There's a small amount in other currencies like the

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yen and the Swiss Franc.

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Uh, so it's roughly a three way split.

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However, if you analyze that a little more carefully,

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for example, looking at the amount held relative

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to the amount available,

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Europeans hold the vast majority of the bonds

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that are denominated in Europe's.

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Okay? So that's suggesting they have a very strong

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preference for euro denominated bonds.

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Perhaps not surprisingly, this is that home currency bias

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that I referenced earlier.

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And, statistical analysis of the cross section

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of holdings shows that the currency, denomination

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of the bond is the most important characteristic.

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If you're trying to predict how much European investors hold

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of a bond, that's more important than who the issuer is.

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Uh, what sector, government versus private country

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currency is more important than all of that.

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So this is, again, this, this matches

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what has been shown earlier in the literature

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that investors really prefer their home currency.

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After that sort of descriptive, look at the,

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this extensive data set, we then turn

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to our most important analysis,

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which is in the time series dimension,

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how do these holdings change over time?

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What are the flows in and out of emerging market bonds?

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And the first major finding, is that consistent

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with the existing literature, the us,

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the broad US dollar is a good barometer,

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for risk appetite that it's highly correlated with flow.

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So periods of strong dollar

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European investors are pulling out of emerging market bonds,

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weaker dollar, they're going into emerging market bonds.

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So that matches the existing literature at that level.

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However, then we are able to go,

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drill down deeper given this very nice data set.

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And the first thing that we find is if you split

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by currencies, if you look at flows,

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not just in the aggregate,

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but by different currencies, the flows

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to euro denominated bonds are not

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sensitive to the broad dollar.

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They are remarkably stable.

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So the flows to the dollar

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and local currency are, are fickle,

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but not the flows to the European denominated bonds.

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In fact, we find that over our sample that we analyze

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for 34 consecutive quarters, there were inflows into

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emerging market bonds denominated in euros.

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Again, stark contrast to the ups

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and downs we see in local currency

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and dollar denominated bonds.

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So this adds a new dimension

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to the existing literature on home currency bias.

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Previous studies have shown in the cross section,

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there's a preference for the home currency bonds.

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This shows not just a preference,

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but a stability of the flows.

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They continue to go in, no matter what's going on

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around the world, no matter what's going on with,

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other financial markets continue

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to buy the Euro denominated bots.

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So that's our first sort of major, result.

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But then we go forward

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and we wanna know, well, what about the, the,

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the volatile flows, the volatile flows to local currency

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and dollar denominated bots?

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What risk is it, that's driving those,

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fickle flows?

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And for the local currency, this is the emerging market.

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Local currency bonds.

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The, the obvious risk here is the currency itself. Okay?

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So these currencies are quite volatile.

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Uh, you can imagine a European investor holding a

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peso denominated, Mexican bond, for example.

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And, and so not only are they facing the risk

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of the emerging market, sovereign

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or corporate, the credit risk,

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but they're also facing the currency fluctuations.

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And those two tend to go together so that it kind

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of doubles up on the risk of those bonds.

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And sure enough that when we do the empirical analysis

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and look at the, how sensitive these flows are,

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to local currency fluctuations, it is in fact the currencies

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that are, depreciating.

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We see that the Europeans are pulling out of those, okay,

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during the, the risk off cycles.

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Okay? So that's the local currency side currency risk.

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Pretty straightforward story there.

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But what about the dollar denominator bonds?

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We also see fickleness there.

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And at first that might be a little surprising, right?

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Because the dollar is considered a safe haven.

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Uh, so why are we pulling out of dollar denominated bonds

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during the risk off cycle?

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And if you think about it, it's not the currency

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dimension of return.

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'cause if you're a European investor

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during a strong dollar period, that's adding to the return

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of the bond, the dollar is appreciating.

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So that's helping you. And yet you're selling that bond.

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So what would it be?

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Well, we hypothesize that it goes back

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to the story about currency

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mismatches that I mentioned earlier.

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Maybe the investors are worried that during periods

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of dollar appreciation, the borrower is subject to

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a balance sheet risk.

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So think specifically about a emerging market government.

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They're issuing bonds denominated in dollars,

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but they collect taxes and payso.

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And so when the dollar appreciates the burden of

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that debt gets strong, gets larger, right?

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There's takes more paces to pay off that bond.

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And so there's an increased chance

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that they won't be able to do it.

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Uh, so the default risk on that bond goes up.

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And so what we find in fact, when we test

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that hypothesis is that European investors are,

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attuned to that specific risk.

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We find that the governments

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that borrowed more extensively in foreign currency,

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that have bigger foreign currency debts relative to the size

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of their economies, those are the ones

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where there's the sell offs

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or the pullouts during the risk off, cycle.

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When the broad dollar appreciates European investors are

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specifically selling the emerging market sovereign bonds

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that have large FX debt burdens,

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then we can even go a little bit further

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and say more general credit risk is also a risk factor.

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Uh, the general credit risk we're proxying for

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with yield spreads.

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Uh, again, our detailed data set at the security level gives

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us the yield spread, both at the sovereign level,

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and we find this also matters at the, corporate

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or private bond market.

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So emerging markets, emerging market borrowers

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who have larger yield spreads, those are the ones

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that the market considers to be less credit worthy.

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Those are the bonds that are experiencing the sell offs,

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the outflows during the broad dollar appreciation.

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So it's not sort of indiscriminate flight,

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it's selling the riskiest of the portfolio,

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whether it be balance sheet risks or general credit risk.

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Main results can be nicely highlighted

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by looking at a few recent shocks or two case studies.

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We call them the, the covid shock of 2020 quarter one

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and the fed rate hikes that began in 2022.

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So on the top panel

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of the graph in the top left corner specifically,

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you'll look at the flows from emerging market bonds

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during the 2020 quarter one,

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and the left bar shows in the aggregate euro

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and area investors sold off emerging market bonds.

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That's probably not that surprising, right?

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So during this, this big shock, a little bit

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of this risk off behavior,

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however, the, the aggregate sales

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of 2% is what we find

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mask interesting differentiation across currencies.

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So the next three bars in that top left corner show that

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for Euro denominated bonds, there are actually

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positive inflows, significant inflows, 6%.

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So even during c Euro area,

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investors were buying euro denominated bonds from emerging

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markets, which might be thought of as a risky asset, right?

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Euro, but the home currency preference is

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so strong they continue to go into those during covid.

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Now the, the graph shows that there were major sales

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of local currency denominated bonds, about 10%

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outflows from local currency bonds.

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And that, is consistent with the fact

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that the lo emerging market currencies did very

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poorly during that time.

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There was worry about how, emerging markets would,

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get through this period, worry about everybody getting

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through it, but especially emerging markets.

14:39.235 --> 14:41.855
Uh, and then you look at the US dollar denominated bar

14:41.855 --> 14:43.015
and it's slightly positive,

14:43.015 --> 14:45.735
and that at first suggests nothing going on there.

14:46.005 --> 14:47.895
However, we can drill a little deeper.

14:48.115 --> 14:51.585
And in the top right panel you see that actually

14:51.615 --> 14:55.905
that aggregate kind of nothing on us dollar masks,

14:56.775 --> 14:59.785
some areas of outflows and some areas of inflows,

15:00.325 --> 15:04.705
and specifically the US dollar denominated bonds issued

15:04.805 --> 15:06.065
by sovereigns

15:06.605 --> 15:08.465
and the sovereigns that were more likely

15:08.465 --> 15:10.065
to have currency mismatches.

15:10.095 --> 15:12.785
That is have large FX debt burdens.

15:13.355 --> 15:15.145
Those were being sold off.

15:15.955 --> 15:19.175
So that matches this, this balance sheet mismatch

15:19.815 --> 15:21.255
hypothesis that we talked about earlier.

15:21.875 --> 15:23.695
And we know that the currencies we're doing poorly,

15:23.705 --> 15:25.055
local currencies were depreciating.

15:25.595 --> 15:27.855
And so investors were particularly attuned.

15:27.855 --> 15:29.455
Okay, where is that a problem?

15:29.555 --> 15:32.455
That's a problem if the government borrowed a lot in dollars

15:32.635 --> 15:34.335
and they might not be able to pay back.

15:34.355 --> 15:35.815
So investors were selling off

15:36.115 --> 15:38.895
of those specific dollar denominated bonds.

15:40.375 --> 15:43.555
And then if we turn to the second case study that is

15:43.575 --> 15:44.675
of the fed rate hikes,

15:44.675 --> 15:47.755
and those are in the bottom part of the graph, start

15:47.755 --> 15:50.075
with the bottom left corner there, we see that

15:50.585 --> 15:54.235
overall in aggregate, maybe surprisingly,

15:54.295 --> 15:56.515
the leftmost bar says there was not much

15:56.515 --> 15:58.395
of an outflow from emerging market bonds

15:58.415 --> 16:00.195
during this period of fed rate hikes.

16:01.345 --> 16:03.445
But again, that headline number

16:04.055 --> 16:06.565
masks very important differentiation by currency

16:06.835 --> 16:08.325
that you might not observe if you

16:08.325 --> 16:09.565
didn't have a great data set.

16:10.025 --> 16:12.605
And so when you drill deeper, you see, actually

16:13.335 --> 16:16.165
there were in European investors were selling off the

16:16.165 --> 16:17.285
dollar denominated bonds.

16:17.695 --> 16:19.125
There were major outflows,

16:19.145 --> 16:22.525
almost 5% outflows from dollar denominated bonds.

16:23.405 --> 16:26.275
Again, now transition to the right bottom right panel,

16:26.735 --> 16:31.045
we see that again, there's indication that specifically

16:31.875 --> 16:35.005
it's balance sheet risks that investors were worried about.

16:35.715 --> 16:37.815
The governments that borrowed extensively in foreign

16:38.175 --> 16:40.615
currency, they're the ones with a mismatch.

16:40.615 --> 16:42.095
And so investors are selling those.

16:42.675 --> 16:46.535
And on the private side, the private sector borrowers

16:47.085 --> 16:50.055
that are in non tradable sectors, why is that important?

16:50.215 --> 16:51.575
'cause if you're in a non tradable sector,

16:51.995 --> 16:53.695
you don't have dollar revenue.

16:54.565 --> 16:56.305
If you're an exporter, you have dollar revenue

16:56.365 --> 16:57.425
and you're not mismatched.

16:57.605 --> 17:00.505
But a non exporter is mismatched.

17:00.505 --> 17:02.745
And investors were, we're worried about those two.

17:02.845 --> 17:04.785
So both governments

17:05.325 --> 17:08.785
and corporates that had potential mismatch risks,

17:09.315 --> 17:11.705
those are the ones that investors were selling off

17:11.925 --> 17:14.265
during the fed rate hikes of 2022.

17:14.565 --> 17:17.905
So the first major finding is about the home currency bias.

17:18.375 --> 17:20.825
It's that we strengthened

17:20.845 --> 17:22.985
and elaborated on that, result.

17:23.685 --> 17:27.535
And if investors are so,

17:28.775 --> 17:30.275
prefer their home currency and

17:30.275 --> 17:33.435
and provide stable flows to home currency bonds, well that

17:33.965 --> 17:36.675
gives an opportunity to emerging market borrowers

17:37.135 --> 17:38.875
to cater to that preference.

17:39.475 --> 17:41.475
Emerging market borrowers, be they corporations

17:41.535 --> 17:43.715
or governments, are then gonna want

17:43.715 --> 17:46.515
to issue bonds in a number of different currencies.

17:46.945 --> 17:49.285
It's not just gonna be about local currency

17:49.345 --> 17:53.045
and dollar, which some, seem to focus exclusively on.

17:53.475 --> 17:55.445
Instead, they're gonna want to borrow some in Euro

17:55.465 --> 17:58.285
and we show that, that there's very significant investment

17:58.345 --> 17:59.645
in the euro denominated bonds

17:59.825 --> 18:01.885
and they're probably also gonna wanna issue some in yen

18:01.885 --> 18:03.445
and some other major currencies

18:03.445 --> 18:05.965
because the investors want to hold those bonds

18:06.425 --> 18:09.685
and they're less fickle about their holdings in those bonds.

18:10.825 --> 18:13.255
Now that's the, the positive side,

18:13.835 --> 18:15.615
but we also have to realize

18:15.645 --> 18:19.255
that emerging market borrowers need to be careful,

18:19.305 --> 18:21.855
about overdoing it in borrowing and foreign currents

18:21.875 --> 18:23.615
and be careful about those balance sheet risks

18:23.615 --> 18:26.575
because our results show that investors are sensitive,

18:26.575 --> 18:30.695
they're attuned to that risk, and that if a sovereign

18:30.955 --> 18:34.215
or a corporation is borrowing extensively in foreign

18:34.535 --> 18:36.655
currency and they don't have the dollar assets

18:36.915 --> 18:40.455
or euro assets, into to balance that risk,

18:41.125 --> 18:44.535
investors are gonna be ready to pull out,

18:44.615 --> 18:45.695
during times of stress.

18:46.355 --> 18:48.455
So the second major implication is

18:49.175 --> 18:50.535
emerging market borrowers need

18:50.535 --> 18:52.535
to be careful about those mismatch risks.

18:53.715 --> 18:56.335
And then the last sort of big picture,

18:56.655 --> 18:58.935
takeaway from our study is that

18:59.815 --> 19:03.085
although there's extensive, understanding

19:03.085 --> 19:06.805
of a risk on risk off cycle, sometimes it's painted

19:06.945 --> 19:11.125
as if there are sort of indiscriminate flows in

19:11.125 --> 19:12.845
and out of emerging economies.

19:13.465 --> 19:15.245
Uh, but our results show

19:15.245 --> 19:16.925
that it's, it's not quite like that.

19:16.925 --> 19:19.725
When you look at the granular data, you see that investors

19:20.425 --> 19:23.285
do differentiate based on currency,

19:23.285 --> 19:25.925
denomination based on balance sheet risks

19:26.305 --> 19:27.885
and based on general credit risks.

19:28.745 --> 19:31.285
So it's not blind flight in and out.

19:31.555 --> 19:34.845
Investors are highly attuned to the risks

19:35.345 --> 19:36.885
of these emerging market borrowers.

00:00 - The paper is, first of all, I wanna acknowledge this joint work with Martin Bormans of the Dutch, central Bank, and the has been published in the Journal of International Economics. The context, for our study is that there is

00:16 - a, a risk on risk off cycle that investors tend to go through. And, and you read about that in the financial press, but there's also an extensive academic literature exploring this tendency of investors to sometimes rush into, riskier assets and then other times sort of pull back or we say retrench into safe assets. and this fickleness of, of global investors is particularly important for emerging markets.

00:45 - And hence, we focus our analysis on emerging market economies. And they're vulnerable to this, this inflow outflow global cycle, because they may, during the good times get used to being able to borrow at relatively low rates and, and it will help, stimulate their economies. But then, when a bump comes in the road and investors pull out, that could be quite disruptive. Now, this is, this is all well documented.

01:13 - our angle is that we have access to very detailed granular data, and that enables us to look a little deeper and say, okay, investors have this risk on risk off cycle, but what risks specifically are investors worried about? And what is it that triggers these, on off episodes, one of the branches of the literature has recently focused on the broad US dollar as a barometer of risk appetite for global investors. Okay? And the, the, sometimes this is linked also

01:47 - to federal reserve policy. So you can imagine periods when the Federal Reserve is raising interest rates, and the dollar tends to get stronger. The literature shows that those periods are, when we see this risk off, attitude that, investors will sell risky assets including emerging market assets, and they'll retrench to safe assets, including, the US Treasury as, as one predominant, global safe assets.

02:14 - And then other periods when you see, interest rates falling and the Fed being more expansionary and the dollar tending to depreciate, that triggers the, the risk on periods. Okay? So the do the broad dollar has become an indicator for the risk cycle. Most of the analysis is rather US-centric, or again, the dollar being the dominant currency. The US investors get a lot of attention. so we add another dimension

02:45 - by looking at it from the European perspective. And so we're able to see, well, is this broad dollar, also important for European investors? and then we're also adding another dimension because we're able to bring a third currency into the analysis. So rather than just looking at dollar denominated assets and local emerging market denominated assets, what about the Euro denominated assets? What role do they play in this sort of triangulation

03:12 - that we're able to, to do? And that's important, because if you don't have, if you just look at dollars versus local currency, it's hard to tease out how much of this is flight to the global safe currency, versus just coming to a home currency. And so with the European perspective, now you have three dimensions. You have a home currency, which is the Euro.

03:35 - You have the global safe currency, the dollar, and then the local currency in emerging markets. So that allows us to take a different angle and get new perspectives. one additional branch of the literature that's, associated with our study would be the borrower perspective. So the borrowers, we know that there's an extensive literature saying that when emerging markets borrow in foreign currency,

04:04 - that introduces risk to their balance sheet. So they're borrowing in one currency, but they may have revenue in their own local currency, and that's called a currency mismatch. and those are risks that we know have caused crises in the past. In emerging markets, we're mostly focused on the investor perspective. So we're wondering, do investors pay attention to those risks, and are they specifically attuned to which

04:28 - emerging market borrowers have those mismatches? We are very fortunate in this paper to have an outstanding data set, a very detailed granular data set provided by the European Central Bank, and it has security level holdings by Euro area investors of financial assets we're focused on, again, on emerging markets, and we're focused on emerging market bonds. And this detailed data set tells us which bonds, Euro area investors are whi which bonds are held

05:02 - by Euro area investors, and how those holdings change over time. so we start with a descriptive look at this data, and we established that ary investors, first of all, they are very significant holders of these bonds. So we find that in many cases, ary investors hold over 10% of the amounts outstanding. But that's a significant share of the bonds issued by these corporates and sovereigns, in emerging economies. And then, the currency dimension that I had mentioned

05:39 - before, that three-way currency dimension, if you look, look, look at just the raw data. We see that European investors, roughly speaking, have a three-way split. About one third of their bonds, that they hold are denominated in the local emerging market currencies. About one third are dollar denominated, and the last third are Euro denominated. There's a small amount in other currencies like the

06:04 - yen and the Swiss Franc. so it's roughly a three way split. However, if you analyze that a little more carefully, for example, looking at the amount held relative to the amount available, Europeans hold the vast majority of the bonds that are denominated in Europe's. Okay? So that's suggesting they have a very strong preference for euro denominated bonds. Perhaps not surprisingly, this is that home currency bias

06:31 - that I referenced earlier. And, statistical analysis of the cross section of holdings shows that the currency, denomination of the bond is the most important characteristic. If you're trying to predict how much European investors hold of a bond, that's more important than who the issuer is. what sector, government versus private country currency is more important than all of that. So this is, again, this, this matches what has been shown earlier in the literature

07:03 - that investors really prefer their home currency. After that sort of descriptive, look at the, this extensive data set, we then turn to our most important analysis, which is in the time series dimension, how do these holdings change over time? What are the flows in and out of emerging market bonds? And the first major finding, is that consistent with the existing literature, the us, the broad US dollar is a good barometer,

07:35 - for risk appetite that it's highly correlated with flow. So periods of strong dollar European investors are pulling out of emerging market bonds, weaker dollar, they're going into emerging market bonds. So that matches the existing literature at that level. However, then we are able to go, drill down deeper given this very nice data set. And the first thing that we find is if you split by currencies, if you look at flows, not just in the aggregate,

08:02 - but by different currencies, the flows to euro denominated bonds are not sensitive to the broad dollar. They are remarkably stable. So the flows to the dollar and local currency are, are fickle, but not the flows to the European denominated bonds. In fact, we find that over our sample that we analyze for 34 consecutive quarters, there were inflows into emerging market bonds denominated in euros.

08:29 - Again, stark contrast to the ups and downs we see in local currency and dollar denominated bonds. So this adds a new dimension to the existing literature on home currency bias. Previous studies have shown in the cross section, there's a preference for the home currency bonds. This shows not just a preference, but a stability of the flows. They continue to go in, no matter what's going on

08:53 - around the world, no matter what's going on with, other financial markets continue to buy the Euro denominated bots. So that's our first sort of major, result. But then we go forward and we wanna know, well, what about the, the, the volatile flows, the volatile flows to local currency and dollar denominated bots? What risk is it, that's driving those, fickle flows?

09:16 - And for the local currency, this is the emerging market. Local currency bonds. The, the obvious risk here is the currency itself. Okay? So these currencies are quite volatile. you can imagine a European investor holding a peso denominated, Mexican bond, for example. And, and so not only are they facing the risk of the emerging market, sovereign or corporate, the credit risk, but they're also facing the currency fluctuations.

09:45 - And those two tend to go together so that it kind of doubles up on the risk of those bonds. And sure enough that when we do the empirical analysis and look at the, how sensitive these flows are, to local currency fluctuations, it is in fact the currencies that are, depreciating. We see that the Europeans are pulling out of those, okay, during the, the risk off cycles. Okay? So that's the local currency side currency risk. Pretty straightforward story there.

10:20 - But what about the dollar denominator bonds? We also see fickleness there. And at first that might be a little surprising, right? Because the dollar is considered a safe haven. so why are we pulling out of dollar denominated bonds during the risk off cycle? And if you think about it, it's not the currency dimension of return. 'cause if you're a European investor during a strong dollar period, that's adding to the return

10:44 - of the bond, the dollar is appreciating. So that's helping you. And yet you're selling that bond. So what would it be? Well, we hypothesize that it goes back to the story about currency mismatches that I mentioned earlier. Maybe the investors are worried that during periods of dollar appreciation, the borrower is subject to a balance sheet risk. So think specifically about a emerging market government.

11:11 - They're issuing bonds denominated in dollars, but they collect taxes and payso. And so when the dollar appreciates the burden of that debt gets strong, gets larger, right? There's takes more paces to pay off that bond. And so there's an increased chance that they won't be able to do it. so the default risk on that bond goes up. And so what we find in fact, when we test that hypothesis is that European investors are,

11:38 - attuned to that specific risk. We find that the governments that borrowed more extensively in foreign currency, that have bigger foreign currency debts relative to the size of their economies, those are the ones where there's the sell offs or the pullouts during the risk off, cycle. When the broad dollar appreciates European investors are specifically selling the emerging market sovereign bonds that have large FX debt burdens,

12:06 - then we can even go a little bit further and say more general credit risk is also a risk factor. the general credit risk we're proxying for with yield spreads. again, our detailed data set at the security level gives us the yield spread, both at the sovereign level, and we find this also matters at the, corporate or private bond market. So emerging markets, emerging market borrowers who have larger yield spreads, those are the ones

12:35 - that the market considers to be less credit worthy. Those are the bonds that are experiencing the sell offs, the outflows during the broad dollar appreciation. So it's not sort of indiscriminate flight, it's selling the riskiest of the portfolio, whether it be balance sheet risks or general credit risk. Main results can be nicely highlighted by looking at a few recent shocks or two case studies. We call them the, the covid shock of 2020 quarter one and the fed rate hikes that began in 2022.

13:14 - So on the top panel of the graph in the top left corner specifically, you'll look at the flows from emerging market bonds during the 2020 quarter one, and the left bar shows in the aggregate euro and area investors sold off emerging market bonds. That's probably not that surprising, right? So during this, this big shock, a little bit of this risk off behavior, however, the, the aggregate sales

13:44 - of 2% is what we find mask interesting differentiation across currencies. So the next three bars in that top left corner show that for Euro denominated bonds, there are actually positive inflows, significant inflows, 6%. So even during c Euro area, investors were buying euro denominated bonds from emerging markets, which might be thought of as a risky asset, right? Euro, but the home currency preference is so strong they continue to go into those during covid.

14:14 - Now the, the graph shows that there were major sales of local currency denominated bonds, about 10% outflows from local currency bonds. And that, is consistent with the fact that the lo emerging market currencies did very poorly during that time. There was worry about how, emerging markets would, get through this period, worry about everybody getting through it, but especially emerging markets. and then you look at the US dollar denominated bar

14:41 - and it's slightly positive, and that at first suggests nothing going on there. However, we can drill a little deeper. And in the top right panel you see that actually that aggregate kind of nothing on us dollar masks, some areas of outflows and some areas of inflows, and specifically the US dollar denominated bonds issued by sovereigns and the sovereigns that were more likely to have currency mismatches.

15:10 - That is have large FX debt burdens. Those were being sold off. So that matches this, this balance sheet mismatch hypothesis that we talked about earlier. And we know that the currencies we're doing poorly, local currencies were depreciating. And so investors were particularly attuned. Okay, where is that a problem? That's a problem if the government borrowed a lot in dollars and they might not be able to pay back.

15:34 - So investors were selling off of those specific dollar denominated bonds. And then if we turn to the second case study that is of the fed rate hikes, and those are in the bottom part of the graph, start with the bottom left corner there, we see that overall in aggregate, maybe surprisingly, the leftmost bar says there was not much of an outflow from emerging market bonds during this period of fed rate hikes.

16:01 - But again, that headline number masks very important differentiation by currency that you might not observe if you didn't have a great data set. And so when you drill deeper, you see, actually there were in European investors were selling off the dollar denominated bonds. There were major outflows, almost 5% outflows from dollar denominated bonds. Again, now transition to the right bottom right panel,

16:26 - we see that again, there's indication that specifically it's balance sheet risks that investors were worried about. The governments that borrowed extensively in foreign currency, they're the ones with a mismatch. And so investors are selling those. And on the private side, the private sector borrowers that are in non tradable sectors, why is that important? 'cause if you're in a non tradable sector, you don't have dollar revenue. If you're an exporter, you have dollar revenue

16:56 - and you're not mismatched. But a non exporter is mismatched. And investors were, we're worried about those two. So both governments and corporates that had potential mismatch risks, those are the ones that investors were selling off during the fed rate hikes of 2022. So the first major finding is about the home currency bias. It's that we strengthened and elaborated on that, result.

17:23 - And if investors are so, prefer their home currency and and provide stable flows to home currency bonds, well that gives an opportunity to emerging market borrowers to cater to that preference. Emerging market borrowers, be they corporations or governments, are then gonna want to issue bonds in a number of different currencies. It's not just gonna be about local currency and dollar, which some, seem to focus exclusively on.

17:53 - Instead, they're gonna want to borrow some in Euro and we show that, that there's very significant investment in the euro denominated bonds and they're probably also gonna wanna issue some in yen and some other major currencies because the investors want to hold those bonds and they're less fickle about their holdings in those bonds. Now that's the, the positive side, but we also have to realize that emerging market borrowers need to be careful,

18:19 - about overdoing it in borrowing and foreign currents and be careful about those balance sheet risks because our results show that investors are sensitive, they're attuned to that risk, and that if a sovereign or a corporation is borrowing extensively in foreign currency and they don't have the dollar assets or euro assets, into to balance that risk, investors are gonna be ready to pull out, during times of stress. So the second major implication is

18:49 - emerging market borrowers need to be careful about those mismatch risks. And then the last sort of big picture, takeaway from our study is that although there's extensive, understanding of a risk on risk off cycle, sometimes it's painted as if there are sort of indiscriminate flows in and out of emerging economies. but our results show that it's, it's not quite like that.

19:16 - When you look at the granular data, you see that investors do differentiate based on currency, denomination based on balance sheet risks and based on general credit risks. So it's not blind flight in and out. Investors are highly attuned to the risks of these emerging market borrowers.

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