The Role of Foreign Currency Debt in Financial Crises : 1880-1913 vs. 1 9 72-1997

1. The Role of Foreign Currency Debt in Financial Crises : 1880-1913 vs. 1972-1997 Michael Bordo Rutgers University and NBER and Christopher M. Meissner University of Cambridge

2. Introduction • The earlier era of globalization 1870-1914 was rife with frequent emerging market currency crises, banking crises, and debt crises, with resonance for the recent past. • Many emergers suffered from “original sin” (Eichengreen and Hausmann 1999) - - the external debt that they accumulated was almost strictly denominated in foreign currency or in terms of gold (or had gold clauses). • When the exchange rate depreciates, debt service in gold or foreign currency becomes very difficult leading to default, and the consequent drying up of external funding. • The emerging country experience was in contrast to that of the advanced core countries which were financially mature, had credibility and could issue bonds denominated in terms of their own currency. • There were few crises in these countries.

3. In this paper we ask : • (a) whether these different debt structures might have played a role in explaining the difference in crisis incidence. • (b) whether debt management policies that created or alleviated balance sheet mismatches mattered (Goldstein and Turner 2004). • (c) whether poor reputation and accumulated default experience was a problem (Rienhart, Rogoff and Savastano 2003). • We have developed a database to allow us to identify and distinguish “original sin” and balance sheet crises from more traditional currency and banking crises for roughly 30 countries (both advanced and emerging) from 1880-1914. We also have data for over 40 countries between 1972 and 1997 for the post Bretton Woods period. Our data covers both crisis incidence and determinants. • Our results do not find unambiguous support for the idea that hard currency debt for emerging markets is always associated with more financial turbulence.

4. For the 1880 -1913 period we find evidence that emerging markets with significant amounts of original sin can be divided into two sub-groups: • Argentina, Brazil, Chile, Italy and Portugal each of which suffered a financial catastrophe between 1880 and 1913 • Australia, Canada, New Zealand, Norway, and the US, which had relatively little trouble with financial crises. • For the recent period we find that: • Countries like Argentina, Thailand, Indonesia and Brazil look like the former set for 1880-1913. • (b) Greece, Ireland, Israel, Spain, Sweden and Singapore look similar to the latter set • The difference between the two groups of countries we ascribe partially to good debt management and partially to special country characteristics that vary over time.

5. We also argue that there are two other sets of countries: • most peripheral regions that suffer from original sin, but are closed to international capital flows and hence have avoided crises. • most advanced economies without original sin, which have strong financial systems and few currency and debt crises. • We also find that debt management matters even after controlling for the level of original sin. • Many countries matched their hard currency liabilities with hard currency reserves. This helped reduce exposure to currency and banking crises. • Countries with better international repayment records were able to avoid debt crises despite high levels of debt.

6. Framework • We view banking trouble, currency crises and debt crises as inter-related phenomena. It draws on Mishkin (2003). • One scenario is a rise in international interest rates which worsens the balance sheets, leads to declining net worth, a rise in performing loans or a decline in lending. A sudden stop or current account reversal may take place leading to further financial stress. Governments may have trouble servicing debt as capital markets become unwilling to roll over debt. The capital flow reversal could lead to abandonment of the peg and a large depreciation. • In the face of original sin, deprecation can led to increases in the real value of debt. The decline in net worth can lead to further disintermediation. • Ceteris Paribus, deterioration in balance sheets would be more severe the greater the amount of fixed interest rate hard currency debt outstanding. • Countries insure themselves against exchange rate movements by backing up hard currency debt by hard currency assets.

7. Measuring Original Sin • According to Eichengreen and Hausman (1999) foreign currency denominated debt was imposed by international capital markets. Nations with poor reputations, and even nations with good reputations or solid fundamentals, are obliged to issue debt in key international currencies. • The literature so far has done little to ascertain how harmful is original sin. We attempt to do this by examining the empirical association between original sin and financial crises. • Our measure of original sin for the 1880-1913 period is the ratio of hard currency public debt to total public debt. We define hard currency debt as debt that carried a gold clause or was made payable at a fixed rate in a foreign currency. • A key difference between our measure and that used by others is we look at debt issued in domestic and international markets instead of only international issues. The reason is that pre 1914 many domestic issues carried gold clauses.

8. For the 1972-1997 period we use the measure of original sin defined in Eichengreen Hausmann, and Panizza (2005). • The Eichengreen et al data base is only available for the period 1993-1997. To broaden the time span of our sample, we calculate the within country average of the observations and use this average values for all the years in which a country appears in the data set. • The key difference between the two measures we use, the inclusion of domestic original sin in the historical database. Evidence presented by Eichengreen et al suggests that for the most part their measure of original sin is highly correlated with domestic original sin.

9. Figure 1 shows the ratio of hard currency government debt to total government debt by country between 1880 and 1913. • Most countries original sin was constant over time. • Figure 2 shows the evolution of the original sin between 1993 and 1997. We tend to see strong persistence • Figure 3 shows long-run averages of original sin for 1880-1913. • Financial centres have less original sin. • Small peripheral countries have a lot of original sin. • Countries with ostensibly rotten fiscal institutions and poor international track records have intermediate levels of original sin. • Figure 4 shows the 1993-1997 country averages of original sin. It shows that both some very advanced countries like Belgium, Finland, Ireland, and Sweden have high original sin as do really all emerging market countries.

10. Figure 1: Hard Currency Debt as a Percentage of Total Public Debt, 1880-1913

11. Figure 2: The Evolution of Original Sin in Sample Countries 1993-1997

12. Figure 2: (cont.) The Evolution of Original Sin in Sample Countries 1993-1997

13. Figure 3: Average Ratio of Hard Currency Public Debt to Total Public Debt, 1880-1913

14. Figure 4: Average Level of Original Sin Between 1993 and 1997

15. Figure 4 (cont.)

16. Currency Mismatches andDebt Intolerance • Goldstein and Turner (2004) argue that currency “mismatches” are the main problem with foreign currency debt. On the margin, changes in the exchange rate can become a problem the greater the mismatch as local currency assets lose value in terms of the foreign liabilities. • Our measure of mismatches for country i is where reserves are gold reserves. • The measure above risks combining flow measures (exports) with stock measures. As an alternative measure, we use the total amount of interest payments due in gold or foreign currency. • For the recent period we use the total of external debt given in the World Bank’s Global Development Finance.

17. Debt Intolerance • Reinhart, Rogoff and Savastano (2003)suggests that past defaults generate poor sovereign ratings. • For the nineteenth century we account for default history by: (a) interacting the public debt to government revenue ratio with an indicator variable that equals one if a country had at least one default episode between 1800 and 1880. (b) interact the debt to revenue ratio with an indicator equal to one if the country is in the periphery. • For the twentieth century we use the ratio of debt to output. We interact this ratio with an indicator that equals one if there was a default in the country between 1824 and 1971. • If the increase in the probability of a financial crisis for a marginal increase in the debt to revenue or debt to GDP ratio is larger for a peripheral country or a past defaulter, we would argue there is evidence in support of the debt intolerance hypothesis.

18. Crises • Figure 5 presents the frequency of various types of crises (banking, currency, twin, debt, “third generation” crises and all types of crisis together). • We define a crisis as Third generation if there was a debt crises accompanied by either a banking crisis, a currency crisis or both. • The figure shows the frequency of crises – the number of years a country was in crises divided by total possible years of observation. • For the pre 1914 period we see the pattern in Bordo et. al. (2001) that the predominant form of crises before 1914 were banking crises, followed by currency crises, twin and then debt crises. • The more recent period seems much more crisis prone in virtually all dimensions. • Figures 6 and 7, 8 and 9 present scatter plots of the percentage of time a country was in a crisis episode versus our measure of original sin and our mismatch variables.

19. Figure 5: Crisis Frequency in Percentage Probability per Year, 1880-1913 vs. 1972-1997

20. Figure 6: Crisis Frequencies By Country versus the Average Level of Hard Currency Public Debt to Total Public Debt, 1880-1913

21. Figure 7: Crisis Frequencies By Country versus the Average Level of Original Sin, 1972-1997

22. Figure 8: Crisis Frequencies by Country versus the Average Level of the “Mismatch” Measure, 1880-1913

23. Figure 9: Crisis Frequencies by Country versus the Average Level of the “Mismatch” Measure, 1972-1997

24. Patterns (a) In the pre-World War I era, there appears to be an inverse U relationship between debt crises and original sin. Countries with intermediate ranges of original sin seem to take longer to resolve their debt crises than those at either end of the spectrum. (b) Today there appears to be a direct positive relationship between the severity of debt crises and the average level of original sin and similarly for currency and banking crises. (c) For the mismatch in Figures 8 and 9 there appears to be a positive relationship between mismatches and the length of time spent in a debt crisis. (d) For the nineteenth centurythe quadratic seems to pick up the following: (i) advanced countries have low levels of OS and few crises

25. (ii) The British Dominions, Northern Europe, and the U.S. have high levels of OS and few crises. (iii) In the intermediate range we see Southern Europe, Eastern Europe and Latin America with medium OS and more crises. (e) For both centuries the data suggest that at higher per capita income levels original sin is less likely to cause debt or banking crises.

26. Statistical Results • We use panel probits to ascertain the role of measures of original sin, currency mismatch and debt intolerance in precipitating the various types of crises. • In addition to the measures of balance sheet strength we control for a number of standard determinants of crises including: total government debt divided by government revenues, growth in the terms of trade, deviation of the exchange rate from the period average, current account to GDP. Yield spread on consols, money growth, gold reserve to note circulation.

27. Basic Results (1) We find that more original sin may increase the likelihood of banking and debt crises, but that there is an important interaction with the level of development and other factors. (2) We find that the positive marginal effect of increased original sin or hard currency debt on debt crises in both periods and banking crises in the twentieth century is smallerat the highest levels of per capita income. (3) This suggests that original sin may contribute to more financial crises but that sometimes the damage can be limited as the development process continues. (4) There is solid evidence that mismatches are positively correlated with many types of crises.

28. (5) We find that debt crises are associated with the outbreak of a currency crisis in both periods. (6) To some extent the evidence shows that debt crises are associated with banking crises. (7) We find that banking crises and currency crises are more positively associated in the nineteenth century than the twentieth century. This evidence suggests that conditional on having a crisis, episodes of instability tended to be more systemic in the past than today.

29. Debt Crises • Table 1 shows the results for 1880-1913. • Column 1 shows an inverse U shaped pattern in original sin, in mismatches and there is evidence of debt intolerance. • These are the countries in the areas of recent settlement which had strong financial systems, good fiscal institutions intent and which borrowed largely for productive investments. • Most of the control variables have signs that fit our priors. • We interpret the quadratic in original sin as saying that more original sin is associated with a higher likelihood of a debt crisis, but those observations with very high levels of original sin face a lower likelihood. • See figure 10 which shows the shape of the marginal effect of various values of the hard currencies debt to total debt ratio. And figure 11 which presents the predicted probabilities of a debt crisis for various values of the ratio of hard currency debt to total debt.

30. Table 1: Determinants of Debt Crises

31. Figure 10: Marginal Effect of the Ratio of Hard Currency Debt to Total Debt

32. Figure 11: Predicted Probabilities of a Debt Crisis, 1880-1913

33. Table 2 shows the results for debt crises for the 1972-1997 period. • Column 1 shows there is a positive relationship between our measure of original sin and debt crises. • Column 4 shows that mismatches increase the susceptibility to debt crises • Column 3 shows the interaction between GDP per capita and original sin. Middle income countries, emerging markets are the most prone to have a crisis. See figure 12.

34. Table 2: Determinants of Debt Crises, 1972-1997

35. Figure 12 suggests that we can break the sample of countries into 3 categories where original sin is high: • to the left the poor countries which don’t rely on external finance • in the middle income emerging markets which rely on external financing • the highly developed countries who either are less exposed or can deal with shocks to the financial system. • Figure 13 classifies countries into 4 groups based on GDP per capita and level of OS. • We then look at the average trade deficit within each group, the average time spent in a debt crisis, the average predicted probability of a debt crisis and the median predicted probability. • We see that the richest countries are lower on all 5 dimensions whereas the middle income are highest.

36. Figure 12: Predicted Probabilities of a Debt Crisis, 1972-1997.

37. Figure 13: “Radar” Chart Showing the Four Part Categorization of Countries

38. Currency Crises • For 1880-1913 with respect to currency crises there is only weak evidence for the role of our balance sheet measures and there is some evidence of a quadratic. See Table 3. • We view most currency crises as a symptom of capital flight from a crumbling financial sector and liquidity problems, and think that indirectlyoriginal sin is associated with currency crises. • We see that initial problems in the banking sector (proxied by one-year ahead indicators of debt crises and banking crises) are strongly associated with currency crises. • For the twentieth century, Table 4 shows evidence that original sin leads to a higher chance of a currency crisis as does the mismatch.

39. Table 3: Determinants of Currency Crises, 1880-1913

40. Table 4: Determinants of Currency Crises, 1972-1997

41. Banking Crises • Banking crises seem to be associated with OS and currency mismatches in both periods but much more so in the nineteenth century. • Between 1880 and 1913 we see a quadratic as we did in Table 1. • Between 1972 and 1997 we see that the impact of more original sin is higher in low and middle income countries than in high income countries. • These results are presented in Table 5 - 6.

42. Table 5: Determinants of Banking Crises, 1880-1913

43. Table 6: Determinants of Banking Crises, 1972-1997

44. Robustness • We check to see if our results - - that after a certain point more hard currency debt relative to the total seemed to be associated with fewer debt crises and banking crises - - are spurious reflecting characteristics of countries left out of the analysis. • Perhaps those most at risk have ways to deal with crises despite their high levels of OS. • To check this we use a fixed effects linear probability model estimated by OLS in Table 7 which covers the early period. • The results on the coefficients on the original sin mismatch variable are similar to those in the previous table. • The results for the twentieth century in Table 8 were similar but less significant.

45. Conclusions • Our key finding is that hard currency debt may not always generate a higher likelihood of a financial crisis. • In both centuries, some countries with high levels of OS averted crises. They tended to be high income and to have backed up their foreign currency debt with hard currency reserves. • We categorize our countries into 4: (a) financial centers with low original sin and strong financial fundamentals obviously avoid crises. (b) smaller advanced countries with high OS also avoided crises. (c) LDC’s which are relatively closed also avoided crises. (d) middle income emergers with open capital accounts are most prone to crises.

46. Our bottom line is that original sin often makes debt crises more likely and makes avoiding currency and banking crises more difficult. • The lesson from two different periods of globalization is that more careful debt management policies and the development of sound fiscal and financial institutions seem to make it possible for governments and firms to avoid severe financial crises.