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

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

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  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 (>1%) Other Developed (9%) Major Financial Centers (64 %) Euroland (26%)

  9. 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

  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) Securities in currency i = - INDEXB 1 i Securities issued by country i

  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) æ ö Securities in currency i ç ÷ = - OSIN 3 max 1 , 0 ç ÷ i Securities issued by country i è ø

  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 <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

  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 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

  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 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

  22. 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

  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 Income declines, debt becomes more costly Currency Depreciates

  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 miner’s 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. OS cannot be explained by weak domestic policies and institutions Too many good guys suffer from it

  30. 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

  32. 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 1993-98 1999-01

  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. 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

  39. 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.

  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 risk

  41. 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

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