11

Currency denomination of debt:The Original Sin of Emerging Markets?

Ricardo HausmannHarvard University

22

MotivationMotivation

The 90s have seen an explosion of financial crisesThe 90s have seen an explosion of financial crises– Mexico, Thailand, Indonesia, Korea, Russia, Brazil, Ecuador, Mexico, Thailand, Indonesia, Korea, Russia, Brazil, Ecuador,

Turkey, Argentina, UruguayTurkey, Argentina, Uruguay

The standard explanation has been weak domestic The standard explanation has been weak domestic policies and moral hazardpolicies and moral hazardThis has lead to an agenda based on increasing the This has lead to an agenda based on increasing the private risks of lendingprivate risks of lending– Reduce bailouts, increase bail-ins, facilitate defaultReduce bailouts, increase bail-ins, facilitate default

There is very little evidence that moral hazard is There is very little evidence that moral hazard is importantimportant– Moral hazard implies too much lending. Debt flows are now Moral hazard implies too much lending. Debt flows are now

negativenegative

I will develop an alternative theory based on incomplete I will develop an alternative theory based on incomplete markets markets

33

Basic argumentBasic argument

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

44

OutlineOutline

Original Sin: Definition and measurementOriginal Sin: Definition and measurement

The Pain: ConsequencesThe Pain: Consequences

The Mystery: What causes itThe Mystery: What causes it

Redemption: How to get over itRedemption: How to get over it

Definitions and MeasurementDefinitions and Measurement

The global cross-border The global cross-border portfolio is highly portfolio is highly

concentrated by currencyconcentrated by currency

77

The global cross-border The global cross-border portfolioportfolio

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

United States EUROLAND Japan U.K Switzerland Canada Australia

Debt by Country

Debt byCurrency

(0.9857)

(0.8859)

88

Major FinancialCenters (64 %)

Euroland(26%)

Other Developed (9%)

Developing (>1%)

Total Debt issued in own currency (93-98)

Major FinancialCenters (34 %)

Total Debt issued by residents (93-98)

Euroland(31%)

Other Developed (14%)

Developing (10%)

99

A First Measure A First Measure (the higher the value, the greater the sin)(the higher the value, the greater the sin)

i

iiOSIN i

country by issued Securities

currency in country by issued Securities11

1010

A Second Measure A Second Measure (which accounts for the fact that debt in currency (which accounts for the fact that debt in currency ii issued by other countries creates an opportunity issued by other countries creates an opportunity

for country for country ii to hedge) to hedge)

i

iINDEXBi

country by issued Securities

currency in Securities1

1111

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

issue)issue)

0,

country by issued Securities

currency in Securities1max3

i

iOSIN i

1212

Measures of original sin by Measures of original sin by country groupingscountry groupings

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Financial Centers Euroland Other Developed Developing

OSIN1 OSIN2 OSIN3

1313

Table 4: Countries with OSIN3 Table 4: Countries with OSIN3 <0.8, excluding financial centers<0.8, excluding financial centers

Non Euroland Euroland Country 1993 -98 1999 -01 Country 1993 -98 1999-01 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

1414

Original sin is highly persistentOriginal sin is highly persistent

00.10.20.30.40.50.60.70.80.9

GoldClauses

MixedClauses

DomesticCurrency

OSIN3 and Flandreau-Sussman classification circa 1850

The Pain of Original SinThe Pain of Original SinConsequencesConsequences

Monetary, fiscal, exchange Monetary, fiscal, exchange rate, volatility, crisesrate, volatility, crises

1616

OS and monetary policyOS and monetary policy

OS makes depreciations potentially OS makes depreciations potentially contractionarycontractionary

Central banks wil tighten moentary conditions to Central banks wil tighten moentary conditions to prevent depreciationsprevent depreciations

……making monetary policy more pro-cyclicalmaking monetary policy more pro-cyclical

They will allow less exchange rate flexibilityThey will allow less exchange rate flexibility– Hols more reserves, allow less exchange rate Hols more reserves, allow less exchange rate

flexibility, allow more reserve volatilityflexibility, allow more reserve volatility

1717

Floating at its best:Australia

4

4.2

4.4

4.6

4.8

5

5.2

5.4

5.6

5.8

61/

1/97

3/1/

97

5/1/

97

7/1/

97

9/1/

97

11/1

/97

1/1/

98

3/1/

98

5/1/

98

7/1/

98

9/1/

98

11/1

/98

1/1/

99

3/1/

99

5/1/

99

7/1/

99

9/1/

99

inte

rest

rat

e

1.2

1.3

1.4

1.5

1.6

1.7

1.8

exch

ange

rat

e

1818

Floating Latin Style: Mexico

15

20

25

30

35

40

45

50

55

1/2/

97

3/2/

97

5/2/

97

7/2/

97

9/2/

97

11/2

/97

1/2/

98

3/2/

98

5/2/

98

7/2/

98

9/2/

98

11/2

/98

1/2/

99

3/2/

99

5/2/

99

7/2/

99

inte

rban

k ra

te

7

7.5

8

8.5

9

9.5

10

10.5

11

exch

ange

rat

e

interbank rate

exchange rate

1919

Table 6: Original sin and Table 6: Original sin and exchange rate flexibilityexchange 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

2020

Fiscal policyFiscal policy

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

2121

The Weak Relationship The Weak Relationship Between Debt/GDP and Between Debt/GDP and

Credit RatingsCredit Ratings

rati

ng

fo

reig

n c

urr

ency

net_debt/gdp-.291965 1.13803

5

19

ARG

AUS

AUT

BEL

BRA

CAN

CHN

CRI

CYP

CZE

DNK

DOM

EST

FIN

DEU

GRC

HUN

ISL

IND

ISR

ITA

JPN

JOR

LVA

MEXMAR

NOR

PAK

PAN

PRY

POL

PRT

SVN

ESPSWE

TTO

TUN

TUR

GBR USA

2222

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

cred

it ra

ting

1992

-99

aver

age

DE_RE2-.579362 4.13906

5

19

ARG

AUS

AUT

BEL

BOLBRA

CAN

CHL

CHN

COL

CRI

CYP

CZE

DNK

DOM

SLV

EST

FIN

DEU

GRCHUN

ISL

INDIDN

ISR

ITA

JORKAZ

KOR

LVA

LUX

MLT

MEX

MNG

MAR

NOR

PAN

PRY

PER

POL

SGP

SVK

SVN

ZAF

ESPSWE

CHE

THA

TUN

TUR

GBR USA

2323

Table 8: Original sin and credit Table 8: Original sin and credit ratingsratings

(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 2.764 (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

2424

The Vicious CircleThe Vicious Circle

Capital Flows get scared

Currency Depreciates

Fiscal and private solvency deteriorates

Income declines, debt becomes more

costly

Pecado Original

Original Sin

2525

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 -14.287 147.265 (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 sinCauses of original sin

Just a miner’s canary?Just a miner’s canary?

2727

Theories based on national Theories based on national failingsfailings

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

2828

International dimensionsInternational dimensions

Large economies trade more with the rest of the Large economies trade more with the rest of the world and develop liquid currency marketsworld and develop liquid currency markets– Correlation between currency market liquidity and OS Correlation between currency market liquidity and OS

in the XIX century (Flandreau and Sussman, 2002)in the XIX century (Flandreau and Sussman, 2002)

Economies of scale in liquidity or network effects Economies of scale in liquidity or network effects favor few currencies favor few currencies Constant international transaction costs and Constant international transaction costs and heterogenous countries favor home bias in large heterogenous countries favor home bias in large countries and foreign bias in small countriescountries and foreign bias in small countries– Hausmann and RigobonHausmann and Rigobon

2929

OS cannot be explained by OS cannot be explained by weak domestic policies and weak domestic policies and

institutionsinstitutions

Too many good guys suffer from itToo many good guys suffer from it

3131

Bottom LineBottom Line

Original sin is not mainly a problem of country Original sin is not mainly a problem of country policies and institutionspolicies and institutionsWe have evidence that it is at least in part a We have evidence that it is at least in part a problem of the international system problem of the international system – Economies of scale in liquidity, network effects, Economies of scale in liquidity, network effects,

may lock in the status quomay lock in the status quo

The current reform agenda may do little to The current reform agenda may do little to eliminate the problemeliminate the problemRedemption therefore may require Redemption therefore may require international actioninternational action

Redemption:Redemption:an international solutionan international solution

3333

Lessons from outliersLessons from outliers

Countries that have recently escaped Countries that have recently escaped original sin seem to have done so original sin seem to have done so through non-nationals issuing debt in through non-nationals issuing debt in domestic currencydomestic currency

IFIs have played a major role in this IFIs have played a major role in this processprocess

Borrowers swap their obligations with Borrowers swap their obligations with residentsresidents

3434

Foreigners issue most of the debt in exotic Foreigners issue most of the debt in exotic currenciescurrencies

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

CzechRepublic

SouthAfrica

New Zealand

Poland HongKong

Denmark Canada Singapore Australia

OSIN 3% Foreign

Countries with OSIN 3 below 0.8, excluding Financial Centers

3535

IFIs are very important in the IFIs are very important in the new OS outliersnew OS outliers

0%10%20%30%40%50%60%70%80%90%

100%

CzechRepublic

Estonia HongKong

Poland Portugal SlovakRepublic

SouthAfrica

Spain

1993-98 1999-01

3636

Why is this so?Why is this so?

Not because of a “developmental” goalNot because of a “developmental” goal– IDB issued in non-member currenciesIDB issued in non-member currencies

Only because it is cheaperOnly because it is cheaper– Swap back into US$Swap back into US$

What makes it more efficient?What makes it more efficient?– Correlation between currency risk and default risk Correlation between currency risk and default risk

makes local instruments inefficientmakes local instruments inefficient– IFIs have no correlation between currency and default IFIs have no correlation between currency and default

riskrisk– Local borrowers on the other end pay to get rid of the Local borrowers on the other end pay to get rid of the

mismatch enough to encourage IFIs to issuemismatch enough to encourage IFIs to issue

3737

Our proposalOur proposal

We propose an index based on an We propose an index based on an inflation-adjusted basket of EM currenciesinflation-adjusted basket of EM currencies– Historically it shows trend appreciation, low Historically it shows trend appreciation, low

volatility and negative correlation with volatility and negative correlation with industrial country consumptionindustrial country consumption

We propose that the WB, other IFIs and We propose that the WB, other IFIs and C-5 governments issue debt in this index C-5 governments issue debt in this index and swap obligations with EMsand swap obligations with EMs

3838

Our proposalOur proposal

Develop an indexDevelop an index– based on a basket of currenciesbased on a basket of currencies– Indexed to inflationIndexed to inflation– GDP PPP weightedGDP PPP weighted

We show that it has three characteristicsWe show that it has three characteristics– Trend appreciationTrend appreciation– Low volatility: very diversifiedLow volatility: very diversified– Negative correlation with consumption in industrial Negative correlation with consumption in industrial

countriescountries

Excellent for a developed country portfolioExcellent for a developed country portfolio

3939

0.3

0.5

0.7

0.9

1.1

1.3

1.5

1.7

198

0Q1

198

1Q1

198

2Q1

198

3Q1

198

4Q1

198

5Q1

198

6Q1

198

7Q1

198

8Q1

198

9Q1

199

0Q1

199

1Q1

199

2Q1

199

3Q1

199

4Q1

199

5Q1

199

6Q1

199

7Q1

199

8Q1

199

9Q1

200

0Q1

200

1Q1

20 in the 80's

22 from 93-02

DM Index

Yen Index

The EM is a stable indexThe EM is a stable index

4040

Appreciation, stability, Appreciation, stability, risk diversificationrisk diversification

Table 20: EM Indexes: Average return, standard deviation and correlation with realprivate consumption.

EM Index 80 (1980-2001) EM Index 93 (1993-2001)Avg. Return St Dev Consumption

Correlation 1Avg. Return St Dev Consumption

Correlation 1

Canada 1.56 10.9 -14.5 1.49 10.5 -33.4France 2.58 13.6 -25.9 2.92 10.2 -36.4Germany 0.73 14.3 12.5 3.14 10.5 -14.5Italy 4.22 14.0 -27.5 3.36 11.1 15.8Spain 4.50 12.9 -62.0 4.30 10.5 -65.4Japan -3.12 13.9 4.3 0.13 11.8 34.3United Kingdom 2.45 12.2 -35.3 -0.24 11.8 -21.4United States 0.27 11.3 -23.4 -0.71 11.6 -25.51Note: 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 realprivate consumption is low.

4141

Step 2. Have the World Bank Step 2. Have the World Bank and other IFIs issue debt in EMsand other IFIs issue debt in EMs

IFIs are AAA, so they have access to a broad asset IFIs are AAA, so they have access to a broad asset classclass

They can hedge their currency exposure by converting They can hedge their currency exposure by converting loans to EM-index members into indexed local loans to EM-index members into indexed local currency loanscurrency loans– They become a solution, not a cause of OSThey become a solution, not a cause of OS

Regional IFIs can swap with the WB or the Regional IFIs can swap with the WB or the governments themselves for non-regional index governments themselves for non-regional index membersmembers

WB would calculate index lowering manipulation riskWB would calculate index lowering manipulation risk

4242

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

Also high-grade non-residents with an interest in Also high-grade non-residents with an interest in lowering global riskslowering global risks

Swap currency exposure with EM-member Swap currency exposure with EM-member countriescountries– This gets read of the mismatchThis gets read of the mismatch

Need not cost them anythingNeed not cost them anything– Make sure by providing put-option on the price of the Make sure by providing put-option on the price of the

swapswap

The swap is much safer than sovereign risk and The swap is much safer than sovereign risk and can be made safercan be made safer

4343

In conclusionIn conclusion

We base our solution on the experience of We base our solution on the experience of outliersoutliers– Role of foreign issuers, IFIs, swapsRole of foreign issuers, IFIs, swaps

We address the cause of OS by offering a We address the cause of OS by offering a well diversified synthetic currencywell diversified synthetic currency

We address the credibility problem of EMs We address the credibility problem of EMs by indexing to inflationby indexing to inflation

Very limited downside risk if attempt to Very limited downside risk if attempt to develop EM market failsdevelop EM market fails