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Yiğit Onay

Yiğit Onay is a Researcher at the CBRT.

Halil İbrahim Korkmaz

Halil İbrahim Korkmaz is a Researcher at the CBRT.

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Understanding the components of local currency bond yields is crucial for the deepening of debt markets and the reduction of borrowing costs in emerging market economies (EMEs) where a significant portion of the government debt is composed of local currency bonds. In these countries, the currency risk premium is one of the most important determinants of local currency-denominated sovereign bond yields (Domowitz et al. (1998)). The currency risk premium can be basically defined as the extra yield demanded to cover the risk of depreciation in local currency against reserve currencies (Du et al. (2013)). Investors who want to hold local currency-denominated sovereign bonds ask for the rate on US Treasury bonds, an investment instrument that is deemed risk-free, and the credit risk premium that reflects the country’s default risk, in addition to the currency risk premium that they demand in return for a possible depreciation of the local currency against reserve currencies. In this regard, a country’s local currency sovereign bond yield can be decomposed into three components having the same maturity: the US treasury bond yield, the credit risk premium, and the currency risk premium (1). Based on this definition consistent with the academic literature, the currency risk premium (CRP) can be expressed as the residual obtained by excluding the US bond yield rus and credit default swap premium (CDS) from the local currency bond yield for a country (rd): 

This blog post explores the course of the currency risk premium embedded in bond yields for emerging market countries as well as the macroeconomic and global factors that may lead to variations in the currency risk premium across these countries (2)
Chart 1 demonstrates the variation in currency risk premia of selected eight emerging market countries obtained for the period between 2007 and 2017 using daily data (3). Currency risk premia fluctuate throughout the analysis period and also significantly vary across countries. The grey area showing the maximum and minimum currency risk premium values for the related period in EMEs excluding Turkey implies that currency risk premium differs across periods while the currency risk premium of Turkey occasionally diverges from the risk premia of other EMEs. In fact, Turkey’s risk premium has displayed an upward trend since 2017 whereas the average of peer countries’ risk premia has been relatively stable.

Average annual bond yields in sample countries are decomposed into the currency risk premium and other factors (US bond yield and credit risk) to reveal the role of the currency risk premium in the course of EMEs’ local currency bond yields (Chart 2). For the period between 2007 and 2017, the currency risk premium accounts for 3.9 percentage points of the average local currency bond yield of 7.9% in EMEs while the remaining 4 percentage points are associated with the US bond yield and the sovereign credit risk. For the case in Turkey, 6.6 percentage points of the average  Turkish lira bond yield, which was 11% during the same period, are attributed to the currency risk premium and 4.4 percentage points to other factors (4). In other words, for the analysis period, the currency risk premium accounts for almost half of the average EME yield whereas it corresponds to three fifths of the yield in Turkey. 

Under the methodology employed to decompose bond yields into their components, the currency risk premium obtained by adjusting the average bond yield spread between EMEs and the US for EMEs’ credit risk is expected to smooth out the real interest rate spreads among countries and the remaining series to largely reflect the cross-country inflation expectation spreads. As a matter of fact, for the EME group, there is a significantly strong relationship between the average currency risk premium and the EME-US inflation expectation spread (Chart 3). This relationship reveals that the factors affecting the currency risk premium in selected EMEs shape bond yields mostly through the channel of inflation expectations (5).

The study by Korkmaz and Onay (2018) explores the role of macroeconomic, global and political uncertainty variables in the change in currency risk premium in EMEs. According to the findings of the study, country-specific macroeconomic variables are significant in explaining the variation of currency risk premium across emerging market countries and its variation over time. Foreign currency reserves, public debt stock and net international investment position (NIIP) stand out as the macro indicators that are found to be significant. Accordingly, consistent with a priori expectations, increases in FX reserves, improvements in the NIIP, and declines in public debt stock contribute to lowering the currency risk premium by enhancing countries’ room for maneuver against speculative exchange rate movements, curbing the external financing requirement, and increasing the resilience of countries’ economies to domestic and external shocks, respectively. 

Results indicate that stock variables such as the NIIP and public debt stock play a more important role in the determination of currency risk premium than flow variables such as current account balance and budget balance. On the other hand, it is notable that inflation and growth volatilities are found to be more significant compared to inflation and growth rates. These variables are deemed to be important in terms of explaining the cross-country variations in macroeconomic uncertainty. It is observed that average annual inflation rates become significant but the performance of the model drops when the volatility variables are excluded from the model.

Estimates made by including different variables into the model to test the significance of global variables imply that global variables are not statistically significant. This finding is interesting in that it reveals that for the overall sample, countries’ currency risk premia are affected more by country-specific macroeconomic factors than by global variables such as the Dollar Index (DXY) and the S&P 500 Volatility Index (VIX). These results suggest that domestic factors may be more dominant in emerging market countries such as Turkey whose macro indicators vary. The study also demonstrates that growth and inflation volatility indicators directly affect the currency risk premium and accordingly the borrowing cost. 

When the results for the determinants of currency risk premium in EMEs are analyzed in terms of policy makers, it is assessed that monetary and fiscal policies addressing price stability and economic rebalancing will positively affect the functioning of debt markets through the currency risk premium channel. Improvements in macroeconomic vulnerability indicators such as public debt stock sustainability, NIIP and international reserves are crucial to control inflation expectations that are susceptible to these factors and also to reduce the sensitivity of currency risk premium to these variables. 

To sum up, the findings of our study underline that the conjunctural and structural policy framework to be developed to anchor inflation expectations is important in terms of lowering the borrowing costs and enhancing the effectiveness of monetary policy in emerging market countries.

 

(1) The 5-year Turkish bond yields are used in the calculation of currency risk premium in this study, and 5-year US bond yields and CDS premium are also included to account for the term premium.
(2) Detailed results of the related analysis are available in the study by Korkmaz and Onay (2018).
(3) The group of emerging market countries include Brazil, Indonesia, South Africa, Mexico, Peru, Russia, Chile and Turkey.
(4) Figures in the chart have been calculated taking the average for the period between 2007 and 2017. 
(5) For the EME-US inflation expectation spread, 5-year break-even inflation rates have been used. The series has been formulated for the 2012-2018 period while the inflation expectation for EMEs has been calculated  by using monthly average break-even inflation rates of Brazil, Mexico, S. Africa and Turkey whose data are present.
 

References

Korkmaz and Onay, 2018, The Determinants of Currency Risk Premium in Emerging Market Countries, CBRT Research Notes in Economics, 18/06.

Domowitz, I., J. Glen, and A. Madhavan, 1998, Country and Currency Risk Premia in an Emerging Market, The Journal of Financial and Quantitative Analysis, 33 (2): 189-216.

Du, W. and J. Schreger, 2016, Local Currency Sovereign Risk, The Journal of Finance, 71(3): 1027-1070.

IMF, 2016, Development of Local Currency Bond Markets, IMF Staff Note for G20 IFAWG.

Halil İbrahim Korkmaz

Halil İbrahim Korkmaz is a Researcher at the CBRT.

Yiğit Onay

Yiğit Onay is a Researcher at the CBRT.

Note To Editor
For views, suggestions
and comments:
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* The views expressed here are those of the authors. They do not necessarily reflect the official views of the Central Bank of the Republic of Turkey.