Financial repression and bank lending: Evidence from a natural experiment in an emerging market!

Because the early 2000s, local-currency debt (mostly traded in domestic markets) grew to become an increasing and important supply of funding for many governments in emerging market economies. Despite their impressive growth, many domestic sovereign debt markets conserve a captive domestic audience that facilitates direct credit to government. This represents a kind of financial repression 1, be responsible for a crowding from private credit.

The quality of this type of monetary repression depends crucially on government use of foreign credit. If there’s a minimal existence of foreign investors in domestic sovereign debt markets, governments need to depend heavily on domestic banking institutions potentially worsening the crowding from private credit. Consequently, an elevated existence of foreign investors might reduce financial repression, and free sources for that private sector. Consequently local firms might be able to finance more investment projects and boost business activities. Although intuitive, there’s little evidence about this subject due to identification challenges.2 In research conducted recently (Johnson, 2018), I personally use a quasi-natural experiment in Colombia and supply evidence about how the doorway of foreign investors into domestic sovereign debt markets reduces financial repression and increases domestic credit growth, boosting business activities.

Foreign Investors in Domestic Sovereign Debt Markets

For identification I personally use an abrupt, unanticipated shock that triggered the doorway of foreign investors towards the local currency sovereign debt market in Colombia. On March 19th 2014, J.P. Morgan announced the inclusion of countless Colombian treasury bonds into its emerging markets local currency government debt index, the biggest restructuring by J.P. Morgan in a single of their indexes. Because so many worldwide mutual funds track their performance from this index, they altered their portfolio, directing capital inflows towards the Colombian sovereign debt market, and growing their presence (Figure 1).

Figure 1: Foreign Share of Domestic Government Debt Securities

Foreign Share of Domestic Government Debt Securities

Note: This figure is definitely the evolution from the share of domestic government debt securities (TES) held by people from other countries. The dashed line shows a straight line trend while using average growth throughout the 12 several weeks before the announcement from the alternation in the index by J.P. Morgan. The gray bar represents the announcement from the rebalancing by J.P. Morgan.

The doorway of foreign investors had sizable effects on commercial banks depending for their participation within the Treasury market. In Colombia, the Secretary of state for Finance selects banking institutions to do something as market makers within the Treasury market. Each one of the intermediaries taking part in this program is obliged to soak up 4.5 from the total debt from the federal government however market, so that as an advantage, the participating banking institutions get low cost prices through non-competitive auctions however market.

Figure 2: Domestic Sovereign Debt Exposure in Commercial Banks

Domestic Sovereign Debt Exposure in Commercial Banks

Note: This figure shows the evolution of sovereign debt over assets dividing by market maker and non market maker banks in the finish of 2013. The index is built by averaging the development of domestic debt over total assets each and every time. The index is normalized towards the average holdings of sovereign debt over assets for that two groups in Feb 2014. The gray bars indicate the occasions described within the picture.

Following the entrance of foreign investors, market makers, individuals more impacted by the financial repression funnel, reduce their domestic sovereign debt holdings substantially as proven in Figure 2. In line with this funnel, there’s a decrease in the discount compensated through the government to promote makers in non-competitive auctions for government debt securities (Figure 3).

Figure 3: Discount in Primary Market

Discount in Primary Market

Note: This figure shows the evolution from the discount in non-competitive primary market issuances of sovereign bonds in Colombia. It shows time evolution of the discount. The discount is calculated for every bond in every issuance because the secondary market cost divided by primary market cost and substracting 1 from that ratio. Nowhere lines are the typical across bonds for every month with a minimum of some issuance activity. The red dashed lines are the typical before March 2014 (pre) and also the average following the finish of May 2014 (publish). The gray bars indicate the occasions described within the picture.

Effects for Bank Lending and Business Activities

If financial repression was resulting in a crowding from private domestic credit, you ought to observe market-maker banks growing their credit in accordance with all of those other banks. Using data in the city-zone level, I personally use a variations-in-variations specs to exhibit that market maker banks elevated differentially their commercial credit availability by 4.2 percentage points of the assets in comparison to the non-market-maker banks. This finding is highlighted in Figure 3, that depicts the differential credit growth after considering city-zone fixed effects in every quarter. This differential credit growth is indistinguishable from zero in prior to the rebalancing, and becomes positive and significant only throughout the quarters from the rebalancing.3 In addition, the rise in private credit had results around the real economy: industries with greater contact with market makers possessed a greater development in employment, production, sales and GDP throughout the rebalancing period.

Policy Implications

These bits of information have implications regarding using policies to improve the proportion of foreign investors in domestic sovereign debt markets. For example, large emerging countries for example China have a minimal participation of people from other countries within their domestic sovereign debt markets. Furthermore, on March 2016, J.P. Morgan incorporated China on the watch list to go in the GBI-EM. Another consideration is the fact that China might have the biggest weight within the index. Thus, its introduction can lead to home loan business the weights of all of those other countries, ultimately resulting in negative spillovers to another constituents from the GBI-EM.

Finally, results claim that sovereign debt index rebalancing might have effects around the economy past the usual cost effects based in the literature.4 Nowadays, the necessities to go in these indexes are very transparent and available to domestic policy makers. Working for the fulfillment of those prerequisites could be a method to increase and diversify the origin of funding for governments past the much-used domestic banking institutions.

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