November 19, 2007—A new emerging market local currency bond fund, to be co-branded by IBRD with a private partner, is expected to raise $5 billion by early 2008 for investment in up to 40 emerging bond markets.
Gemloc (for Global Emerging Markets Local Currency Bond Fund) is a “systemic” solution to a market gap, said Michael Klein, IFC vice president and chief economist at a press briefing on October 21. While 70 percent of all emerging market debt is currently denominated in local currency, only 10 percent of the foreign money going into bonds issued by emerging markets is denominated in local currency. Only 2 percent of emerging market local currency debt is benchmarked against existing indices.
There is strong demand among investors for a dedicated fund in emerging markets local currency debt that is broadly diversified, said Klein. And while about a dozen emerging economies have already developed liquid local currency bond markets, many others would seek to improve liquidity, build market infrastructure, develop efficient tax regimes, and cut red tape.
The World Bank is looking for a private fund manager for Gemloc to raise the funds—an anticipated $5 billion—in international markets, and to manage a portfolio of investments in local currency bonds across as many as 40 emerging markets. Up to 30 percent of assets could also be invested in sub-sovereign and corporate bonds.
A Virtuous Circle
The fund is not a stand-alone, but a part of a three-part program that also includes an index—the Global Emerging Markets Bond Index (Gemx), co-branded by IFC—weighted not just by size of market, but by “investability” as well, the latter adjusting for such variables as regulatory and tax regimes and market access rules. IFC is not new to the business, having launched the first emerging markets equity index two decades ago.
The aim is not just to provide benchmarks for investors, but create incentives as well to World Bank partner countries to make themselves attractive in this asset class. The third part of the program is technical assistance to be provided by the Bank to help countries develop more investable local bond markets.
This technical assistance will be funded by a “development fee” from the fund manager. There is no capital commitment from either IBRD or IFC in the project overall; and after 10 years the sunset provision kicks in, meaning the “World Bank” name will be removed and the private sector will take over.
Gemloc is part of the Bank’s strategy to develop innovative financial products tailored to countries’ special needs by using the IBRD-IFC’s combined know-how to leverage the impact of modest financial investment.
The Bank Group is betting on a large untapped potential in these markets. Given the historic performance of local currency markets over the last 10 years, Klein said, “if there had been a better way of investing in them against indices, these investments would have even outperformed equity investments in emerging markets, which have done quite well in the longer-term perspective.”
The fund will initially invest in 15 to 20 emerging markets, including Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Peru, the Philippines, Poland, Romania, Russia, Slovakia, South Africa, Thailand, and Turkey. This is expected to grow to 40 markets within five years.
Program is Model of Innovation, IBRD-IFC Cooperation
For the World Bank Group, this represents an opportunity to help open up emerging markets in local currency, while improving the depth and quality of the debt markets, said Klein. In addition to improved financial stability, extended maturities and instruments in local currency enable investment in infrastructure as well as structured finance.
Despite the success of emerging market equity markets, bond markets have developed more slowly in many countries. There are a number of explanations, says Oliver Fratzscher, Gemloc program manager—among them that equity capital is perceived as more helpful for development. In addition, obstacles in the financial market infrastructure remain, taxes are at times prohibitive, and ”red tape” prevents access for a broader group of investors.
“It is now conceivable that reserve managers and pension funds from emerging markets may be allowed to invest in a new vehicle, namely a diversified portfolio of emerging market local currency bonds, which would dramatically expand the investor base and create South-South investment opportunities,” Fratzscher said.
“These markets today attract a lot of hot money, derivative money for three to six months from off-shore centers that go in and out of the country and don’t do anything for development,” said Fratzscher. “And we really want to help bring these short-term hot money flows into onshore longer-term stable investments from institutional investors—both from official and private institutional investors.”
Gemloc also responds to a G8 Action Plan for the development of local bond markets announced in May by finance ministers meeting in Potsdam. They identified development of local bond markets as one of the domestic market structures critical to continued financial stability in emerging markets, and called on the IMF and Bank to provide suggested mechanisms.
Board praises IBRD-IFC cooperation on innovative product
The Board endorsed the Gemloc program on October 4, and a number of executive directors praised it for its innovativeness and for its demonstration of the potential of IBRD-IFC cooperation.
The Bank’s Executive Director for Central America, Mexico, Spain, and Venezuela, Jorge Familiar, also addressed reporters at the Annual Meetings launch, saying, “I applaud Gemloc for its ingenious approach to encouraging financial development through market-based initiatives."
“This project demonstrates that the World Bank Group has a unique role to play in addressing market gaps, bringing public and private sectors together to meet the demands of both, and meeting the needs of middle-income, as well as poor countries.”
The multi-dimensional solution developed by the Bank was necessary to address market obstacles, said Familiar. “It’s usually hard to attract investors if you don’t have liquidity in a market. It’s hard to have liquidity if you don’t have investors,” he said.
And he described Gemloc as an example of South-South cooperation, by putting together markets with different degrees of development and allowing smaller markets to benefit from being included in a fund with more developed ones.