Via IMF (Den Internationale Valutafond)

The Local Stress Index: A New Tool to Summarize Local Market Conditions, and an Application to the South African Local Market

Tobias Adrian
Financial Counsellor and Director, Monetary and Capital Markets Department
International Monetary Fund

October 27, 2020

Thank you very much for your invitation to join you at this discussion of
the fourth edition of the Absa “Africa Financial Markets Index.”

Since its launch in 2017, the AFMI has become an important reference point
for policymakers, investors and analysts as they consider the development
of financial markets across the continent. This year’s edition takes a
deeper look than ever before into Africa’s financial markets, assessing
conditions in key geographies across six key areas: market depth; access to
foreign exchange; market transparency; taxation and the regulatory
environment; macroeconomic opportunity; and the legality and enforceability
of standard financial markets master agreements.

This is a turbulent time for the global economy — and especially for
Africa, as the COVID-19 pandemic causes painful disruptions for many
Emerging Markets. They were already under intense pressure before the
pandemic, with currencies depreciating, growth slowing and interest rates
rising. Many of them — particularly Low-Income Countries — now confront
dire public-health challenges and stark social tensions, and some face the
prospect of debt distress.

Financial markets in these economies have been continuously becoming more
complex across different products. Since the Global Financial Crisis of a
decade ago, the currency and interest-rate derivative markets have
increased in volume and sophistication, while non-residents have become
dominant players in select local-currency bond markets. This has created
the need for policymakers to monitor the signals derived from different

In Chapter 2 of the October 2020 edition of the IMF’s Global Financial
Stability Report
entitled, “Emerging and Frontier Market Economies: A Greater Set of Policy
Options to Restore Stability” — we introduce our “Local Stress Index” (LSI)
as a tool to address this need. The LSI is constructed from local currency
market liquidity and stress indicators — such as bid-offer spreads,
realized volatility, and other risk-premium measures for local currency
bonds and exchange rates.

The usefulness of the LSI is most evident when we use it to look at the
impact of the COVID-19 shock. It brings into sharp focus the rapid
deterioration of financial conditions that was propagated by the shock,
across risk assets. Policymakers in wealthier economies were able to
deliver an unprecedented policy response, with far-reaching fiscal and
monetary measures to restore market functioning — but policymakers in
poorer economies had much less latitude for action.

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The LSI confirms that the overall stress in EM local markets has been
comparable to the impact of the Global Financial Crisis of 2008 and 2009.
However, the pace of the deterioration of market conditions, as well as
their subsequent normalization, was unprecedented. There is also a notable
difference in terms of the behavior of currency and bond markets.

The stress in currency markets was less severe and conditions normalized
more quickly, thanks to the rapid policy response by major central banks,
including the swift establishment of dollar liquidity lines by the Federal
Reserve. Structural changes in Emerging Market currency markets, such as
decentralization and the shift to more electronic trading, may also have
played an important role.

The stress in local currency bond markets, however, was larger than in any
of recent crisis, including the shock of 2008 and 2009. Three significant
factors may have contributed to that stress. First, the COVID-19 response
was significantly more skewed toward fiscal policy, which naturally
increased pressure through bond supply risks. Second, Emerging Market local
bond markets have become much more integrated with the global financial
system, and non-residents are often the largest group of investors in
local-currency bond securities. Third, local market depth has not matched
higher non-resident participation, with the domestic investor base often
remaining underdeveloped. By contract to Advanced Economies, which have
many insurance and pension funds, domestic banks are often the sole
alternative liquidity providers in Emerging Market economies.

Developments in South Africa provide a useful case study. South African
financial markets are among the most developed across Emerging Markets.
Non-resident holdings of local government bonds stood around 35 percent of
the total debt stock just before the pandemic. While a high degree of
integration with global financial markets is often a positive factor, it
can lead to increased volatility spillovers from other developed economies
as well as from Emerging Markets. The COVID-19 shock has been particularly
challenging for South Africa, because it entered the pandemic with weak
economic growth as well as limited fiscal-policy space.

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South Africa’s currency market experienced significant pandemic-related
stress that reached a crescendo in early April. Realized and
options-implied volatility jumped to levels not seen since the Global
Financial Crisis. But the extent of the dollar liquidity shortage, as
measured by the currency basis, was much less pronounced compared to the
crisis of a decade ago, and the widening of bid-ask spreads was also

South Africa’s domestic bond market, by contrast, experienced an
unprecedented shock, when analyzed through the LSI measure. Even now, it
has not yet fully normalized. Prior to the pandemic, investors were already
concerned about the country’s fiscal developments and about the prospect of
further credit downgrades. This seems evident, judging by elevated asset
swap spreads as well as the steep bond yield curve. The global FCI shock
coincided with a major credit downgrade, which, in turn, led to the
exclusion of local bonds from the World Government Bond Index. As a result,
the level of outflows, volatility and deterioration of liquidity (as was
evident from the widening of bid-offer spreads) signaled severe distress in
the bond market. While volatility has subsided and bid-offer spread have
normalized, the risk premium in the bond market remains elevated,
reflecting bond supply risk as well as absence of non-resident inflows.

The developments followed a similar pattern in other major Emerging
Markets, including Brazil, India, Indonesia, Mexico, Poland and Turkey. The
COVID-19 shock led to a “sudden stop” in local bond markets, which had been
a reliable source of financing over the past decade. This factor coincided
with a rapid growth in budget financing needs due to governments’ fiscal
stimulus response. Moreover, a number of Emerging Markets saw the
exhaustion of conventional monetary policy space, with policy rates reduced
to all-time lows.

Given this unique set of circumstances, many Emerging Market economies
introduced asset purchase programs (APPs) for the very first time. The
decision to introduce APPs is likely to have been supported by the
increased credibility of Emerging Market central banks’ inflation-targeting
regimes, as well as by the positive experience of Advanced Economies with
their APPs. The programs introduced in Emerging Markets varied in scope,
scale and modality, but they were united by their primary objective of
restoring market functioning at the height of pandemic-induced turbulence.

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The analysis carried out by the October 2020 edition of the GFSR concludes
that APPs had a positive impact on bond markets by lowering yields,
improving market liquidity, and reducing the eventual, overall level of
stress, as measured by the LSI. At the same time, APPs did not lead to
currency depreciation or increased stress in currency markets, as is
evident from the LSI. In the aggregate, countries that introduced APPs saw
a swifter reduction of stress in local markets by comparison to countries
without such programs. That said, further research needs to be carried out
as the APPs progress and diverge on cross-country basis.

So, as I mentioned, the LSI has served as a useful indicator in identifying
stressed conditions in the COVID-19 episode. We hope that it can become a
yardstick for policymakers when they measure financial-market stress in the
future. The LSI aims to provide a coherent summary of market condition
across multiple liquidity, activity and risk-premia indicators — while also
capturing contagion effects by considering the increase in correlations
during crises.

This methodology was pioneered by the European Central Bank for the SovCiss
index, but the IMF is the first to apply it to a broad set of Emerging
Markets. The Fund will continue developing the LSI and will share the
results in an upcoming IMF Working Paper, as well as through other avenues.

We believe that the “Local Stress Index” (LSI) will be a useful tool for
policymakers as they consider various countries’ economic conditions. I’m
pleased to share these ideas about the LSI with you today, and I invite you
to continue exploring the reasoning within our latest edition of the GFSR —
which offers useful ideas for policymakers worldwide, in Advanced Economies
and Emerging Markets alike.

Thank you very much. Now I’d be pleased to discuss any questions you may

IMF Communications Department


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