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Currency denomination of debt: The Original Sin of Emerging Markets?. Ricardo Hausmann Harvard University. Motivation. The 90s have seen an explosion of financial crises Mexico, Thailand, Indonesia, Korea, Russia, Brazil, Ecuador, Turkey, Argentina, Uruguay

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slide1

Currency denomination of debt:

The Original Sin of Emerging Markets?

Ricardo Hausmann

Harvard University

motivation
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
basic argument
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
outline
Outline
  • Original Sin: Definition and measurement
  • The Pain: Consequences
  • The Mystery: What causes it
  • Redemption: How to get over it
the global cross border portfolio
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

slide8

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

(>1%)

Other Developed

(9%)

Major Financial

Centers (64 %)

Euroland

(26%)

a first measure the higher the value the greater the sin
A First Measure (the higher the value, the greater the sin)

Securities

issued

by

country

i

in

currency

i

=

-

OSIN

1

1

i

Securities

issued

by

country

i

slide10

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)

Securities

in

currency

i

=

-

INDEXB

1

i

Securities

issued

by

country

i

slide11

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)

æ

ö

Securities

in

currency

i

ç

÷

=

-

OSIN

3

max

1

,

0

ç

÷

i

Securities

issued

by

country

i

è

ø

measures of original sin by country groupings
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

table 4 countries with osin3 0 8 excluding financial centers
Table 4: Countries with OSIN3 <0.8, 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

original sin is highly persistent
Original sin is highly persistent

OSIN3 and Flandreau-Sussman classification circa 1850

the pain of original sin consequences

The Pain of Original SinConsequences

Monetary, fiscal, exchange rate, volatility, crises

os and monetary policy
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
slide17

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

slide18

Floating Latin Style:

Mexico

55

11

50

10.5

exchange rate

45

10

40

9.5

interbank rate

exchange rate

35

9

30

8.5

interbank rate

25

8

20

7.5

15

7

1/2/97

5/2/98

1/2/99

7/2/99

3/2/97

5/2/97

7/2/97

9/2/97

1/2/98

3/2/98

7/2/98

9/2/98

3/2/99

5/2/99

11/2/97

11/2/98

table 6 original sin and exchange rate flexibility
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

fiscal policy
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
the weak relationship between debt gdp and credit ratings
The Weak Relationship Between Debt/GDP and Credit Ratings

NOR

JPN

GBR

AUT

DEU

USA

19

SWE

DNK

CAN

BEL

AUS

ESP

FIN

ITA

PRT

CYP

ISL

SVN

rating foreign currency

CZE

ISR

EST

CHN

GRC

LVA

HUN

TUN

POL

TTO

PAN

IND

MEX

CRI

ARG

MAR

DOM

BRA

JOR

PRY

TUR

PAK

5

-.291965

1.13803

net_debt/gdp

debt to tax ratios do remarkably poorly as predictors of ratings
Debt to tax ratios do remarkably poorly as predictors of ratings

NOR

LUX

CHE

AUT

GBR

DEU

USA

19

SGP

SWE

DNK

CAN

BEL

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

CRI

ARG

PER

MAR

TUR

KAZ

DOM

BOL

JOR

BRA

PRY

MNG

5

-.579362

4.13906

DE_RE2

table 8 original sin and credit ratings
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

the vicious circle
The Vicious Circle

Fiscal and private solvency deteriorates

Capital Flows get scared

Pecado Original

Original Sin

Income declines, debt becomes more costly

Currency Depreciates

output and capital flow volatility
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

causes of original sin

Causes of original sin

Just a miner’s canary?

theories based on national failings
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)
international dimensions
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
os cannot be explained by weak domestic policies and institutions

OS cannot be explained by weak domestic policies and institutions

Too many good guys suffer from it

bottom line
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
lessons from outliers
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
foreigners issue most of the debt in exotic currencies
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

why is this so
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
slide37

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
our proposal
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
the em is a stable index
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

appreciation stability risk diversification

Table 20: EM Indexes: Average return, standard deviation and correlation with real

private consumption

.

EM Index 80

EM Index 93

(1980-2001)

(1993-2001)

Avg. Return

St Dev

Consumption

Avg. Return

St Dev

Consumption

1

1

Correlation

Correlation

Canada

1.56

10.9

-14.5

1.49

10.5

-33.4

France

2.58

13.6

-25.9

2.92

10.2

-36.4

Germany

0.73

14.3

12.5

3.14

10.5

-14.5

Italy

4.22

14.0

-27.5

3.36

11.1

15.8

Spain

4.50

12.9

-62.0

4.30

10.5

-65.4

Japan

-3.12

13.9

4.3

0.13

11.8

34.3

United Kingdom

2.45

12.2

-35.3

-0.24

11.8

-21.4

United States

0.27

11.3

-23.4

-0.71

11.6

-25.5

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.

step 2 have the world bank and other ifis issue debt in ems
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
step 3 have c 5 countries issue debt denominated in index
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
in conclusion
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