The sell-off in emerging market currencies has waved a reg flag over the amount of foreign currency bonds issued by EM corporates. The global stock of such bonds has ballooned from barely $100 billion 20 years ago to more than $2 trillion today, raising fears of an emerging bubble.

As currencies slide, the fear is, EM corporates with foreign currency debts paid out of local currency revenues will be pushed towards default. But should investors also be worried about local currency bonds issued by EM sovereigns? That is the question raised in a paper by Jesse Schreger of Harvard University and Wenxin Du of the Federal Reserve Board.

It may sound like a nonsensical suggestion. After all, many EM sovereigns have worked hard to reduce their foreign currency liabilities and borrow instead in their own currencies, after learning the lessons of the emerging market debt crises of the 1980s, 1990s and early 2000s. And the ability of sovereigns to print money surely puts default on debts in their own currency out of the question?

Unless governments exclude them, foreign investors can buy EM debt denominated in foreign or local currency. The paper’s authors note that, 10 years ago, in their selection of 14 emerging markets, 85 per cent of the sovereign debt owed to foreigners was in foreign currency. Today, almost 60 per cent of it is in local currency.

But despite their ability to inflate that debt away, EM sovereigns must still pay a premium to persuade investors to buy their bonds.

One reason, the report’s authors write, is that while sovereigns have reduced their foreign currency liabilities, EM corporates have gone on a foreign currency borrowing binge. If those borrowers are mismatched — if they do not make enough of their earnings in foreign currency to cover their payments, or are not otherwise hedged — “a depreciation could adversely affect firm net worth, which in turn could reduce aggregate output”.

The end result, they argue, is additional default risk on local currency sovereign debt.

How much risk? To answer that, the authors begin by calculating a default-free local currency interest rate for sovereign issuers and demonstrating that such issuers pay a significant premium. On top of this, they find that a 10 per cent increase in the ratio of private foreign currency debt to GDP is associated with an approximately 30 basis point increase in sovereign local currency yields.

The big question is when breaking point comes. When the private sector is highly mismatched, the authors write, sovereigns will be reluctant to allow much exchange rate depreciation. “In this case, [the government] is relatively more inclined to explicitly default than to inflate away the debt because of the effect of depreciation on the private sector.”

EM sovereigns do indeed default on local currency debts. So should we fear a wave of such sovereign defaults in the wake of the currency rout? Schreger, one of the two authors, says not.

“We are still a long way from that,” he says. “The paper is about why in the long run EM local currency sovereign debt is not default free. If I was an investor, I would still be focused on EM foreign currency bonds.”

— Financial Times