During the darkest days of the 2008–2009 financial crisis, emerging market (EM) fixed income showed surprising resilience. From Poland to Mexico to South Korea, local-currency debt markets survived the storm relatively unscathed, buttressed by strong local institutions and sound policy decisions.

Taking notice, investors seeking yield and diversification in the developing world helped to propel the EM local debt to its current size of just over $1.5 trillion—many times bigger than the more familiar hard-currency debt market.

Now, however, EM local debt has hit a crossroads. The waning of monetary stimulus in the U.S. has triggered a sharp price correction—the bellwether local debt index, JP Morgan’s GBI EM, has fallen more than 6% since May 2013.

Notwithstanding that, we see encouraging and important signs for investors seeking strategic exposures to the secular EM growth story.

Significantly, in some of the more advanced emerging economies, the relationship of nominal GDP growth to local interest rates is beginning to resemble that of developed markets. With prospects for more locally driven business cycles, some EM local debt markets may be on the road to becoming truly local.

EM local debt markets are now hardwired into the world’s allocation machinery. Trading volumes of EM local debt reflect this new reality, as does the EM share of global currency trading, which climbed from 4.7 percent in 1998 to 18.7 percent in 2013, BIS data show. EM local debt markets have received new flows from international investors of more than $500 billion since 2009.

Local yield curves and flexible exchange-rate regimes now operate as automatic stabilizers for emerging economies. By absorbing shocks, they are reducing the volatility of real variables and smoothing the macroeconomic adjustment in countries that show unsustainable external or internal imbalances.

Viewed in this light, the recent correction in EM financial asset prices is not a problem. It is part of the solution.

As local markets continue to develop, we can expect local factors to become more important in the dynamics of local interest rates. This would imply that the business and credit cycles will become less dependent on the external environment and that the transmission channels of money policy can become more powerful, ultimately enhancing the links between nominal GDP growth and low interest rates.

Over time, the trend toward locally driven interest rates bodes well for greater economic stability in the developing world. It should also enable international investors to express a more nuanced view on the growth that EM assets have always promised but not always delivered.

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