Domestic markets need to continue efforts to broaden investor base, says IMF

By Reshmi Basu

New York, April 11 - Emerging markets countries need to increase the investor base for locally issued debt, according to the International Monetary Fund's Global Financial Stability Report.

The popularity of emerging market debt instruments has increased in an environment of low interest rates and favorable global liquidity conditions, the report notes.

But it added that cyclical challenges such as higher interest rates, the unraveling of credit cycles and unwinding of liquidity conditions pose threats to emerging markets.

In the report, the IMF conceded the difficulty in quantifying trends, but noted that several noteworthy trends had surfaced. First of all, foreign investors are upping their exposure to domestic currency and local debt. The number of longer-term investors appears to be increasing among both foreign and local investors. And the investor base is expanding geographically as well.

The IMF reported that market sources are noting that central banks in mature markets have begun to invest a portion of their reserves in emerging market debt.

"More importantly, EM central banks, with their own vastly expanded reserve base, are also beginning to invest in EM sovereign debt. Given the size of such reserves, even a small allocation to EM debt could constitute an important class of new foreign investors," the IMF said in the report.

Meanwhile survey data show that the share of foreign creditors in domestically issued debt has doubled to 12% from 6% over the 2000 to 2005 period.

"Positioning, trading, new investment flows and issuance in EM local currency debt remains quite strong," but market sources are suggesting "there is a limited supply of liquid local instruments relative to investor interest," the report said.

According to a survey of institutional investors, of the $210 billion managed by them, 27% was dedicated to local currency assets. Surveys are suggesting that investors are overweighting local currency instruments relative to the historical average.

"EM local currency debt trading has been rising rapidly and is likely to exceed that of foreign currency debt in 2006," the IMF predicted.

Nonetheless, while the increased share of foreign investors in local currency debt is a positive for the asset class, it does highlight the need for good economic and financial policies. More foreign investors on the local front help extend the local currency yield curve as well as increase competitiveness among local markets.

However, foreign investors, more so than their local counterparts, may be more inclined to leave local markets on increased political or economic risks.

But since foreign investors comprise a small part of the overall domestic debt issues, "a change in their position is more likely to be accommodated by net flows between foreign and domestic investors," said the IMF, adding that it is important to continue the efforts to widen and diversify the investor base.

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