How to establish a local bond market and avoid the original sin? Lessons from Germany..

Interesting speech by Andreas Dombert of Bundesbank. She spoke at this conference organised by South African Central Bank.

She says countries should avoid borrowing in other markets which is also called as Original Sin in economics. They should try and develop their own bond markets:

Let me start with a reminder of why we are all here today. True, we have come to talk about local currency bond markets. But why are they important for a country’s financial system?

Time and again, throughout the history of economic development, emerging economies have given in to the temptation to over-borrow abroad, which often gives rise to a significant currency mismatch on their aggregate balance sheets. Risky borrowing in foreign currencies can be tempting because it is often cheaper than raising funds at home – last but not least as foreign creditors accept lower interest rates when the exchange rate risk is born by the debtor. In blunt terms, over-borrowing abroad is called the “original sin” of an emerging currency because – although it comes at low cost in good times – it may cause serious damage to the economy when there is an abrupt currency shift.

In contrast, the existence of a functioning local currency bond market can lower financing costs at home and thereby provide the incentive to reduce foreign currency exposure. In the face of volatile global capital flows, it can therefore help making emerging economies crisis-proof. What is more, sound local currency bond markets support the development of a country’s financial sector and can channel foreign capital into an emerging economy, a valuable source of long-term financing for both the government and the private sector.

Now, some of you may be thinking: Why is a German discussing these issues – given that German sovereign bonds count internationally as “safe haven” investments and are traded on a very deep and liquid market by international standards? To give you my short answer right away: This hasn’t been the case from the outset. In my speech, I would therefore like to draw upon the German story 70 years ago in order to illustrate the lessons we have learned and to outline why this conference may become a catalyst for local bond market development in developing and emerging economies.

She highlights how German bond markets started in 1948:

Let us travel roughly 70 years back in time.

At the end of World War II, Germany and its economy were devastated. Large parts of its industrial plants and of its infrastructure lay in ruins – and so did its financial system. War expenses had been financed via the printing press, and the German currency had lost its value.

It was only in 1948, when the Allied powers governing the country at that time initiated a fundamental reform of the German currency, marking a turning point. The introduction of the D-Mark and the foundation of a new central bank went hand in hand with the transformation of the German economy from a centrally planned to a market-based system. This laid the foundation for what is known as the “German economic miracle” of the 1950s and 60s.

And this is where local currency bond markets come into play. Their development in Germany was already envisaged at the outset of economic policy reforms. But as you might suspect, the German bond market, too, got off to a very bumpy start in 1948. The country and its currency faced a lack of trust -and so did its bond market. People were very hesitant about saving long-term, and many initial public offerings of bonds were disappointing. Just to give you an idea: during the first 18 months of the D-Mark, only about half of all bond IPOs received funding on the infant German capital market.

So we, too, have experienced that political will is one thing and implementation is another, and that establishing a functioning bond market denominated in the local currency hinges on a number of factors.

Let me now single out the aspects of bond market policies in Germany that I believe are still instructive for today’s policymakers.

She singles out prudent regulation and independent central bank which helps in development of the bond markets.


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