Char t i n g t h e C o u r s e t o A N e w N o r m a l
Box 2.1. What determines domestic market yields? Local currency borrowing provides a stable source of financing for emerging market sovereigns. A better understanding of sovereign bond yields’ determinants can help lower the cost of borrowing. This is particularly important in light of a potential tightening in global liquidity conditions and capital outflows from EMDEs. Macroeconomic fundamentals and external conditions are important factors determining the relative borrowing cost across countries. More particularly, the expected monetary policy path, credit risk, inflation risk, exchange rate risk, as well as market structure factors, are possible drivers of a country’s local currency sovereign yields. To provide further insights and compare India’s sovereign yields with the set of peer countries, this box relies on the analytical framework developed by Buzas et al. (2021). The applied methodology estimates panel regressions of a dependent variable (local-currency yield of five-year sovereign bonds) on explanatory variables with country- and time-fixed effects and clustered robust standard errors. Explanatory variables include macro-financial factors (monetary policy rate, real GDP growth rate, inflation expectations, fiscal balance, and current account balance), variables related to the liquidity and stability of the foreign exchange market (currency bid-ask spread and foreign reserve adequacy), and perceptions of political stability (the World Bank’s score of political stability). The sample comprises seven EMDE countries between 2009Q1 and 2019Q2. Figure 2.11. After controlling for macro-financial and foreign-currency market variables, the “India premium” narrows significantly "India Country Premium" on 5-year bond relative to peer countries Percent 6 5 4 3 2 1 0 -1 -2 -3 -4 Malaysia Thailand Colombia Hungary Before controlling for potential explanatory factors
Indonesia
Mexico
Turkey
After controlling for potential explanatory factors
Source: Bloomberg, CEIC, World Bank FinStats, WDI, and staff calculations based on Buzas et al. (2021). Note: Filled bars refer to values significant at the 10 percent level.
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