Transcript Original sin

Currency denomination of debt:
The Original Sin of Emerging Markets?
Ricardo Hausmann
Harvard University
1
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
2
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
3
Outline
Original Sin: Definition and measurement
The Pain: Consequences
The Mystery: What causes it
Redemption: How to get over it
4
Definitions and Measurement
The global cross-border
portfolio is highly
concentrated by currency
The global cross-border
portfolio
(0.9857)
1
0.9
Debt by
Currency
0.8
Debt by Country
(0.8859)
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
United States
EUROLAND
Japan
U.K
Switzerland
Canada
Australia
7
Total Debt issued by residents (93-98)
Other Developed
(14%)
Euroland
(31%)
Developing
(10%)
Major Financial
Centers (34 %)
Total Debt issued in own currency (93-98)
Other Developed
(9%)
Developing
(>1%)
Major Financial
Centers (64 %)
Euroland
(26%)
8
A First Measure
(the higher the value, the greater the sin)
Securities issued by country i in currency i
OSIN 1i = 1 Securities issued by country i
9
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
INDEXBi = 1 Securities issued by country i
10
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)


Securities in currency i
OSIN 3i = max1 ,0 
 Securities issued by country i 
11
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
OSIN1
Other Developed
OSIN2
Developing
OSIN3
12
Table 4: Countries with OSIN3
<0.8, excluding financial centers
Country
Czech Republic
Poland
New Zealand
South Africa
Hong Kong
Taiwan
Singapore
Australia
Denmark
Canada
Non Euroland
1993 -98
1999 -01
0.0
0.00
0.82
0.00
0.63
0.05
0.44
0.10
0.72
0.29
1.00
0.54
0.96
0.70
0.55
0.70
0.80
0.71
0.55
0.76
Country
Italy
France
Portugal
Belgium
Spain
Netherlands
Ireland
Greece
Finland
Austria
Euroland
1993 -98
1999-01
0.00
0.00
0.23
0.12
0.42
0.24
0.76
0.39
0.59
0.42
0.64
0.47
0.94
0.59
0.93
0.60
0.96
0.62
0.90
0.68
13
Original sin is highly persistent
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Gold
Clauses
Mixed
Clauses
Domestic
Currency
14
OSIN3 and Flandreau-Sussman classification circa 1850
The Pain of Original Sin
Consequences
Monetary, fiscal, exchange
rate, volatility, crises
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
16
9/1/99
7/1/99
5/1/99
3/1/99
1/1/99
11/1/98
9/1/98
7/1/98
5/1/98
3/1/98
1/1/98
11/1/97
9/1/97
7/1/97
5/1/97
3/1/97
1/1/97
interest rate
5.6
5.4
1.6
5.2
5
1.5
4.8
4.6
1.4
4.4
1.3
4.2
4
1.2
17
exchange rate
6
Floating at its best:
Australia
1.8
5.8
1.7
7/2/99
5/2/99
3/2/99
1/2/99
11/2/98
9/2/98
7/2/98
5/2/98
25
3/2/98
1/2/98
11/2/97
9/2/97
7/2/97
5/2/97
3/2/97
1/2/97
interbank rate
50
45
10
40
9.5
35
9
30
8.5
interbank rate
8
20
7.5
15
7
18
exchange rate
55
Floating Latin Style:
Mexico
11
10.5
exchange rate
Table 6: Original sin and
exchange rate flexibility
OSIN3
LGDP_PC
OPEN
SHARE2
Constant
Observations
R-squared
(1)
LYS
(2)
RESM2
(3)
RVER
0.984
(2.98)***
0.268
(3.61)***
0.178
(1.85)*
58.719
(0.46)
-1.389
(1.79)*
75
0.22
0.248
(3.74)***
-0.053
(1.85)*
-0.014
(0.41)
-35.858
(0.66)
0.531
(1.73)*
65
0.37
-0.801
(2.02)**
0.026
(0.61)
1.017
(2.88)***
-569.562
(2.36)**
0.104
(0.17)
65
0.62
19
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
20
rating foreign currency
The Weak Relationship
Between Debt/GDP and
Credit Ratings
19
NOR
JPN GBR AUT
DEU
USA
SWE
DNK
ESP
AUS
FIN
CAN
BEL
ITA
PRT
CYP
ISL
SVN
CZE
ISR
EST
CHN
LVA
GRC
POL
TTO
TUN HUN
PAN
IND
CRI
DOM
PRY
MEX
ARG
MAR
BRA
JOR
TUR
5
-.291965
PAK
1.13803
net_debt/gdp
21
Debt to tax ratios do remarkably
poorly as predictors of ratings
19
NOR
LUX
SWE
credit rating 1992-99 average
FIN
CHE
AUT
GBR
DEU
DNK
AUS ESP
USA SGP
CAN
BEL
ITA
CYP
SVN
ISLMLT
CZE
KOR
CHL
EST THA
ISR
LVA CHN
SVK
5
-.579362
POLCOL
HUN
GRC
TUN
ZAF PAN
SLV MEX
IDN
CRI
ARG
TUR
KAZ
DOM BRA
BOL
PRY
MNG
DE_RE2
IND
PER
MAR
JOR
4.13906
22
Table 8: Original sin and credit
ratings
DE_GDP2
(1)
RATING1
-1.553
(1.91)*
DE_RE2
LGDP_PC
OSIN3
Constant
Observations
R-squared
3.189
(8.54)***
-3.429
(3.85)***
-12.369
(3.16)***
56
0.82
(2)
RATING1
-0.599
(1.40)
3.051
(7.59)***
-3.324
(3.49)***
-11.059
(2.60)**
49
0.81
(3)
RATING1
-1.815
(2.19)**
2.884
(6.47)***
-4.883
(3.49)***
-8.751
(1.89)*
51
0.81
(4)
RATING1
-0.665
(1.52)
2.764
(5.68)***
-4.435
(3.11)***
-7.889
(1.57)
44
0.80
23
The Vicious Circle
Fiscal and private solvency
deteriorates
Capital Flows get scared
Pecado Original
Original Sin
Income declines, debt
becomes more costly
Currency Depreciates
24
Output and capital flow volatility
OSIN3
LGDP_PC
OPEN
VOL_TOT
SHARE2
Constant
Observations
R-squared
(1)
VOL_GROWTH
(2)
VOL_FLOW
0.011
(1.96)*
-0.012
(2.14)**
-0.001
(0.12)
-0.000
(0.86)
-14.287
(1.72)*
0.135
(2.25)**
77
0.40
7.103
(3.58)***
-3.214
(2.56)**
-4.181
(1.20)
0.223
(1.08)
147.265
(0.04)
32.825
(2.39)**
33
0.64
25
Causes of original sin
Just a miner’s canary?
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, AghionBachetta-Banerjee)
Exchange rate regimes (Chamon and Hausmann,
Burnside, Eichenbaum and Rebelo)
Political economy (Tirole, 2002)
27
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
28
29
OS cannot be explained by
weak domestic policies and
institutions
Too many good guys suffer from it
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
31
Redemption:
an international solution
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
33
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
34
IFIs are very important in the
new OS outliers
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1993-98
Czech Estonia
Republic
Hong
Kong
1999-01
Poland Portugal Slovak South
Republic Africa
Spain
35
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
36
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
37
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
38
0.3
2000Q1
1999Q1
1998Q1
39
2001Q1
1.3
1997Q1
1.5
1996Q1
1995Q1
1994Q1
1993Q1
1992Q1
1991Q1
1990Q1
1989Q1
1988Q1
1987Q1
1986Q1
1985Q1
1984Q1
1983Q1
1982Q1
1981Q1
1980Q1
The EM is a stable index
1.7
20 in the 80's
22 from 93-02
DM Index
Yen Index
1.1
0.9
0.7
0.5
Appreciation, stability,
risk diversification
Table 20: EM Indexes: Average return, standard deviation and correlation with real
private consumption.
Canada
France
Germany
Italy
Spain
Japan
United Kingdom
United States
EM Index 80 (1980-2001)
EM Index 93 (1993-2001)
Avg. Return St Dev Consumption Avg. Return St Dev Consumption
1
1
Correlation
Correlation
1.56
10.9
-14.5
1.49
10.5
-33.4
2.58
13.6
-25.9
2.92
10.2
-36.4
0.73
14.3
12.5
3.14
10.5
-14.5
4.22
14.0
-27.5
3.36
11.1
15.8
4.50
12.9
-62.0
4.30
10.5
-65.4
-3.12
13.9
4.3
0.13
11.8
34.3
2.45
12.2
-35.3
-0.24
11.8
-21.4
0.27
11.3
-23.4
-0.71
11.6
-25.5
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.
40
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
41
risk
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
42
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
43