Original sin

1
Currency denomination of debt The Original Sin
of Emerging Markets?
Ricardo Hausmann Harvard University
2
Motivation

• The 90s have seen an explosion of financial
  crises
• Mexico, Thailand, Indonesia, Korea, Russia,
  Brazil, Ecuador, Turkey, Argentina, Uruguay
• The standard explanation has been weak domestic
  policies and moral hazard
• This has lead to an agenda based on increasing
  the private risks of lending
• Reduce bailouts, increase bail-ins, facilitate
  default
• There is very little evidence that moral hazard
  is important
• Moral hazard implies too much lending. Debt flows
  are now negative
• I will develop an alternative theory based on
  incomplete markets

3
Basic argument

• Most countries cannot borrow abroad in their own
  currencies
• We referred to this problem four years ago
  (Eichengreen and Hausmann, 1999) as original
  sin
• If a country with OS has a net foreign debt, this
  creates an aggregate currency mismatch in the
  sense that exchange rate movements have aggregate
  wealth effects
• This complicates monetary policy
• it makes exchange rates more rigid
• it makes fiscal policy more complicated
• ..it makes output and capital flows more volatile
• It makes countries crisis-prone

4
Outline

• Original Sin Definition and measurement
• The Pain Consequences
• The Mystery What causes it
• Redemption How to get over it

5
Definitions and Measurement
6
The global cross-border portfolio is highly
concentrated by currency
7
The global cross-border portfolio
(0.9857)
1
Debt
by
0.9
Currency
(0.8859)
0.8
Debt
by Country
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
United States
EUROLAND
Japan
U
.
K
Switzerland
Canada
Australia

8
Total Debt issued by residents (93-98)
Developing (10)
Other Developed (14)
Major Financial Centers (34 )
Euroland (31)
Total Debt issued in own currency (93-98)
Developing (gt1)
Other Developed (9)
Major Financial Centers (64 )
Euroland (26)
9
A First Measure (the higher the value, the
greater the sin)
i
i
currency
in

country
by

issued

Securities
-

OSIN
1
1
i
i
country
by

issued

Securities
10
A Second Measure (which accounts for the fact
that debt in currency i issued by other countries
creates an opportunity for country i to hedge)
i
currency
in

Securities
-

INDEXB
1
i
i
country
by

issued

Securities
11
A Third Measure (which eliminates negative
values, where there is more debt in currency i
than country i has in total, since countries
cannot hedge more debt than they issue)
ö
æ
currency
in

Securities
i

ç
-

0
,
1
max
3
OSIN

ç
i
country
by

issued

Securities
i
ø
è
12
Measures of original sin by country groupings
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Financial Centers
Euroland
Other Developed
Developing
OSIN1
OSIN2
OSIN3
13
Table 4 Countries with OSIN3 lt0.8, excluding
financial centers

Non Euroland


Euroland

Country

1993
-
98

1999
-
01

Country

1993
-
98

19
99
-
01

Czech Republic

0.0

0.00

Italy

0.00

0.00

Poland

0.82

0.00

France

0.23

0.12

New Zealand

0.63

0.05

Portugal

0.42

0.24

South Africa

0.44

0.10

Belgium

0.76

0.39

Hong Kong

0.72

0.29

Spain

0.59

0.42

Taiwan

1.00

0.54

Netherlands

0.64

0.47

Singapore

0.
96

0.70

Ireland

0.94

0.59

Australia

0.55

0.70

Greece

0.93

0.60

Denmark

0.80

0.71

Finland

0.96

0.62

Canada

0.55

0.76

Austria

0.90

0.68


14
Original sin is highly persistent

OSIN3 and Flandreau-Sussman classification circa
1850
15
The Pain of Original SinConsequences

• Monetary, fiscal, exchange rate, volatility,
  crises

16
OS and monetary policy

• OS makes depreciations potentially contractionary
• Central banks wil tighten moentary conditions to
  prevent depreciations
• making monetary policy more pro-cyclical
• They will allow less exchange rate flexibility
• Hols more reserves, allow less exchange rate
  flexibility, allow more reserve volatility

17
Floating at its best Australia
1.8
6
5.8
1.7
5.6
5.4
1.6
5.2
interest rate
exchange rate
1.5
5
4.8
1.4
4.6
4.4
1.3
4.2
1.2
4
5/1/97
7/1/97
9/1/97
1/1/98
3/1/98
5/1/98
7/1/98
9/1/98
1/1/99
3/1/99
5/1/99
7/1/99
9/1/99
1/1/97
3/1/97
11/1/97
11/1/98
18
Floating Latin Style Mexico
55
11
50
10.5
exchange rate
45
10
40
9.5
interbank rate
35
9
exchange rate
30
8.5
interbank rate
25
8
20
7.5
15
7
1/2/97
3/2/97
5/2/97
7/2/97
9/2/97
1/2/98
3/2/98
5/2/98
7/2/98
9/2/98
1/2/99
3/2/99
5/2/99
7/2/99
11/2/97
11/2/98
19
Table 6 Original sin and exchange rate
flexibility

(1)

(2)

(3)


LYS

RESM2

RVER





OSIN3

0.984

0.248

-
0.801


(2.98)

(3.74)

(2.02)

LGDP_PC

0.268

-
0.053

0.026


(3.61)

(1.85)

(0.61)

OPEN

0.178

-
0.014

1.017


(1.85)

(0.41)

(2.88)

SHARE2

58.719

-
35.858

-
569.562


(0.46)

(0.66)

(2.36)

Constant

-
1.389

0.531

0.104


(1.79)

(1.73)

(0.17)

Observations

75

65

65

R
-
squared

0.22

0.37

0.62


20
Fiscal policy

• In bad times, the currency usually weakens
• this increases the cost of servicing the foreign
  debt
• if the central bank avoids depreciation, it will
  raise interest rates, thus increasing the costs
  of servicing the domestic debt
• Hence, debt service becomes pro-cyclical,
  increasing solvency concerns in bad times,
  causing the disappearance of financing in bad
  times
• this causes fiscal policy to become pro-cyclical

21
The Weak Relationship Between Debt/GDP and Credit
Ratings
AUT
DEU
JPN
NOR
GBR
USA
19
BEL
CAN
DNK
SWE
AUS
ESP
FIN
ITA
PRT
CYP
ISL
SVN
rating foreign currency
CZE
ISR
EST
CHN
GRC
LVA
HUN
TUN
POL
TTO
PAN
IND
MEX
ARG
CRI
MAR
BRA
DOM
JOR
PRY
TUR
PAK
5
-.291965
1.13803
net_debt/gdp
22
Debt to tax ratios do remarkably poorly as
predictors of ratings
AUT
DEU
LUX
NOR
CHE
GBR
USA
19
SGP
SWE
BEL
CAN
DNK
AUS
ESP
ITA
FIN
CYP
ISL
MLT
SVN
CZE
KOR
CHL
ISR
THA
credit rating 1992-99 average
EST
CHN
LVA
GRC
TUN
POL
HUN
COL
SVK
PAN
ZAF
IND
MEX
SLV
IDN
ARG
CRI
MAR
PER
TUR
BOL
DOM
JOR
KAZ
BRA
PRY
MNG
5
-.579362
4.13906
DE_RE2
23
Table 8 Original sin and credit ratings

(1)

(2)

(3)

(4)


RATING1

RATING1

RATING1

RATING1

DE_GDP2

-
1.553


-
1.815



(1.91)


(2.19)


DE_RE2


-
0.599


-
0.665



(1.40)


(1.52)

LGDP_PC

3.189

3.051

2.884

2.76
4


(8.54)

(7.59)

(6.47)

(5.68)

OSIN3

-
3.429

-
3.324

-
4.883

-
4.435


(3.85)

(3.49)

(3.49)

(3.11)

Constant

-
12.369

-
11.059

-
8.751

-
7.889


(3.16)

(2.60)

(1.89)

(1.57)

Observations

56

49

51

44

R
-
squared

0.82

0.81

0.81

0.80


24
The Vicious Circle
Fiscal and private solvency deteriorates
Capital Flows get scared
Pecado Original
Original Sin
Currency Depreciates
Income declines, debt becomes more costly
25
Output and capital flow volatility

(1)

(2)


VOL_GROWTH

VOL_FLOW




OSIN3

0.011

7.103


(1.96)

(3.58)

LGDP_PC

-
0.012

-
3.214


(2.14)

(2.56)

OPEN

-
0.001

-
4.181


(0.12)

(1.20)

VOL_TOT

-
0.000

0.223


(0.86)

(1.08)

SHARE2

-
1
4.287

147.265


(1.72)

(0.04)

Constant

0.135

32.825


(2.25)

(2.39)

Observations

77

33

R
-
squared

0.40

0.64


26
Causes of original sin

• Just a miners canary?

27
Theories based on national failings

• Underdevelopment of institutions and policies in
  general
• Inadequate monetary credibility (Jeanne, 2002)
• Fiscal profligacy (Lucas-Stokey, Calvo-Guidotti,
  Corsetti-Mackowiak)
• Moral hazard by the borrower (Chamon,
  Aghion-Bachetta-Banerjee)
• Exchange rate regimes (Chamon and Hausmann,
  Burnside, Eichenbaum and Rebelo)
• Political economy (Tirole, 2002)

28
International dimensions

• Large economies trade more with the rest of the
  world and develop liquid currency markets
• Correlation between currency market liquidity and
  OS in the XIX century (Flandreau and Sussman,
  2002)
• Economies of scale in liquidity or network
  effects favor few currencies
• Constant international transaction costs and
  heterogenous countries favor home bias in large
  countries and foreign bias in small countries
• Hausmann and Rigobon

29
(No Transcript)
30
OS cannot be explained by weak domestic policies
and institutions

• Too many good guys suffer from it

31
Bottom Line

• Original sin is not mainly a problem of country
  policies and institutions
• We have evidence that it is at least in part a
  problem of the international system
• Economies of scale in liquidity, network effects,
  may lock in the status quo
• The current reform agenda may do little to
  eliminate the problem
• Redemption therefore may require international
  action

32
Redemptionan international solution
33
Lessons from outliers

• Countries that have recently escaped original sin
  seem to have done so through non-nationals
  issuing debt in domestic currency
• IFIs have played a major role in this process
• Borrowers swap their obligations with residents

34
Foreigners issue most of the debt in exotic
currencies
1
Foreign
OSIN 3
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Czech Republic
South Africa
New Zealand
Poland
Hong Kong
Denmark
Canada
Singapore
Australia
Countries with OSIN 3 below 0.8, excluding
Financial Centers
35
IFIs are very important in the new OS outliers
1993-98
1999-01
36
Why is this so?

• Not because of a developmental goal
• IDB issued in non-member currencies
• Only because it is cheaper
• Swap back into US
• What makes it more efficient?
• Correlation between currency risk and default
  risk makes local instruments inefficient
• IFIs have no correlation between currency and
  default risk
• Local borrowers on the other end pay to get rid
  of the mismatch enough to encourage IFIs to issue

37
Our proposal

• We propose an index based on an
  inflation-adjusted basket of EM currencies
• Historically it shows trend appreciation, low
  volatility and negative correlation with
  industrial country consumption
• We propose that the WB, other IFIs and C-5
  governments issue debt in this index and swap
  obligations with EMs

38
Our proposal

• Develop an index
• based on a basket of currencies
• Indexed to inflation
• GDP PPP weighted
• We show that it has three characteristics
• Trend appreciation
• Low volatility very diversified
• Negative correlation with consumption in
  industrial countries
• Excellent for a developed country portfolio

39
The EM is a stable index
1.7
20 in the 80's
1.5
22 from 93-02
DM Index
1.3
Yen Index
1.1
0.9
0.7
0.5
0.3
1980Q1
1981Q1
1982Q1
1983Q1
1984Q1
1985Q1
1986Q1
1987Q1
1988Q1
1989Q1
1990Q1
1991Q1
1992Q1
1993Q1
1994Q1
1995Q1
1996Q1
1997Q1
1998Q1
1999Q1
2000Q1
2001Q1
40
Appreciation, stability, risk diversification
1
Note
Correlations with Real Consumption for
France, Germany, Italy and Spain it covers
1980-1998.
For Canada, UK, US and Japan it covers 1980-01. A
negative number indicates that the returns tend
to be high when real
private consumption is low.
41
Step 2. Have the World Bank and other IFIs issue
debt in EMs

• IFIs are AAA, so they have access to a broad
  asset class
• They can hedge their currency exposure by
  converting loans to EM-index members into indexed
  local currency loans
• They become a solution, not a cause of OS
• Regional IFIs can swap with the WB or the
  governments themselves for non-regional index
  members
• WB would calculate index lowering manipulation
  risk

42
Step 3. Have C-5 countries issue debt denominated
in index

• Also high-grade non-residents with an interest in
  lowering global risks
• Swap currency exposure with EM-member countries
• This gets read of the mismatch
• Need not cost them anything
• Make sure by providing put-option on the price of
  the swap
• The swap is much safer than sovereign risk and
  can be made safer

43
In conclusion

• We base our solution on the experience of
  outliers
• Role of foreign issuers, IFIs, swaps
• We address the cause of OS by offering a well
  diversified synthetic currency
• We address the credibility problem of EMs by
  indexing to inflation
• Very limited downside risk if attempt to develop
  EM market fails