Emerging market economy exchange rates and local currency bond markets amid the Covid-19 pandemic

Key takeaways

• Borrowing through domestic currency bonds has not insulated emerging market economies (EMEs) from the financial shock unleashed by Covid-19; EME local currency bond spreads spiked amid sharp currency depreciations and capital outflows.
• Portfolio investors face amplified losses as local currency spreads and exchange rates move in lockstep; their revised portfolio allocations in turn strengthen this correlation.
• EMEs with monetary policy frameworks that are equipped to address the feedback loop between exchange rate depreciation and capital outflows stand a better chance of weathering the financial fallout from the Covid-19 pandemic.
• To counter large stock adjustments in domestic bond markets, EME central banks may need to expand their toolkit to take on a "dealer of last resort" role; a number of them are already moving in this direction.