Cross-Border Bond Investment and Foreign Exchange Market Stability in Emerging Market Economies

Abstract

This paper investigates if the surge in portfolio debt inflows experienced by some emerging market economies after the global financial crisis can pose a serious threat to the stability of their foreign exchange markets. A regression analysis with panel data reveals that portfolio debt outflows are capable of destabilizing foreign exchange markets when they are accompanied by portfolio equity outflows and other investment outflows. The possibility of large investment outflows to disrupt stability in foreign exchange markets and to give rise to currency crises in emerging market economies calls for the use of various forms of capital flow management measures to manage large capital inflows. The counter-factual analysis presented in this paper reveals that capital controls were more effective in reducing portfolio debt investment inflows than non-residency based capital flow management measures were. The same analysis demonstrates that the effects of capital flow management measures on portfolio debt inflows tend to diminish in the longer run. On the contrary, macro-prudential regulations introduced by emerging market economies were effective in managing the external debt of financial institutions in the long run as well as in the short run.