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The Pain and the Mystery of Original Sin

Explore the concept of original sin in international finance, its implications, and various perspectives from leading scholars and critics. Analyze the relationship between original sin and exchange rate flexibility, shedding light on economic vulnerabilities.

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The Pain and the Mystery of Original Sin

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  1. The Pain and the Mystery of Original Sin Barry Eichengreen Ricardo Hausmann Ugo Panizza

  2. Outline and Summary • Definition and Facts • Most countries do not borrow abroad in their own currencies, a problem we refer to as “original sin” • If a country has a net foreign debt, this creates an aggregate currency mismatch • Of course a country can decide not to have a mismatch by not borrowing or holding a lot of reserves • Pain • We show that original sin is associated with limited XR flexibility, high volatility, low credit ratings • Mystery • We show that standard explanations based on poor policies or institutions do not do a good job at explaining original sin

  3. Work on Original Sin • First papers on the topic: • Eichengreen and Hausmann (1999) • Hausmann, Panizza, and Stein (2001) • Hausmann and Panizza (2003) • Original Sin book: • Cespedes, Chang and Velasco, Corsetti and Mackowiak, Jeanne, Jeanne and Zettelmeyer, Flandreau and Sussman, Bordo, Meissner and Redish, Chamon and Hausmann • Critics: • Goldstein and Turner (2003) • Burger and Warnock (2003) • Reinhart, Rogoff, and Savastano (2003) • Eichengreen, Hausmann, and Panizza (2003)

  4. Definition • Eichengreen and Hausmann (1999) definition: “a situation in which the domestic currency is not used to borrow abroad or to borrow long term even domestically” • Here we mostly focus on “international original sin” • Better data on international original sin • Domestic original sin seems easier to solve and some countries are doing progress in this direction • However, we also try to say something on “domestic original sin”

  5. A first look at the problem: Distribution of international debt by issuers and currencies (1999-2001) 1 0.9 Debt by currency 0.8 Debt by country 0.7 $5.6 trillion 0.6 $4.5 trillion 0.5 0.4 0.3 USA Euroland Japan UK Switzerland Canada Australia

  6. Is this because countries do their local currency funding on the home market and foreign currency funding abroad? 100 90 Debt by currency $632 billion 80 70 60 $473 billion 50 40 30 Debt by country 20 10 0 USA EURO JAPAN CANADA UK

  7. Measurement • Measuring original sin is not straightforward • In principle, we want to measure external liabilities in own currency as a share of total external liabilities • We use data gathered by the BIS on the currency denomination of bonds and money market instruments • We also consider BIS data on cross-border bank lending, although the data are less complete (both in country coverage and currency breakdown)

  8. Main index used in the paper æ ö Securities in currency i ç ÷ = - OSIN 3 max 1 , 0 ç ÷ i Securities issued by country i è ø It captures opportunities for hedging through swaps It recognizes that you cannot hedge more than 100 percent of your debt

  9. Alternative indexes securities in currency i issued by country i = - OSIN1 1 securities issued by country i Uses bank loans OSIN2 Like OSIN3 but can take negative values OSIN3b

  10. 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 OSIN3

  11. Original Sin in Developing Countries

  12. Original sin is highly persistent:OSIN and Flandreau-Sussman classification (circa 1850)

  13. The Pain of Original Sin (The consequences)

  14. Exchange rate flexibility • Output and capital flow volatility • Credit ratings

  15. Original Sin and Exchange Rate Flexibility • If an original sin country has a net foreign debt, then there is an aggregate currency mismatch. Movements in the RER will have an aggregated wealth effect • This renders the CB less willing to let the exchange rate move (fear of floating, Calvo and Reinhart, 2002) • As a consequence, the CB holds more reserves and uses them, together with the interest rate, to intervene in the foreign exchange market (Hausmann, Panizza, Stein, 2001)

  16. Original Sin and Exchange Rate Flexibility (1) (2) (3) (4) (5) (6) Dropping Financial Centers LYS RESM2 RVER LYS RESM2 RVER OSIN3 1.503 0.248 - 0.801 1.112 0.339 - 0.598 (3.56)*** (3.74)*** (2.02)** (2.45)** (3.10) *** (1.33) GDP_PC 0.302 - 0.053 0.026 0.285 - 0.052 0.025 (2.89)*** (1.85)* (0.61) (2.77)** (1.81)* (0.56) * OPEN 0.198 - 0.014 1.017 0.153 - 0.014 1.021 (0.92) (0.41) (2.88)*** (0.72) (0.41) (2.93)*** EXD/GDP 0.290 - 0.036 - 0.570 0.297 - 0.030 - 0.544 (0 .96) (0.66) (2.36)** (0.98) (0.54) (2.29)** Constant - 2.188 0.531 0.104 - 1.644 0.435 - 0.084 (1.94)* (1.73)* (0.17) (1.46) (1.35) (0.13) Observations 75 65 65 71 62 62 R - squared 0.37 0.62 0.34 0.65

  17. Original Sin and Exchange Rate Flexibility • The results are generally robust to alternative definitions of original sin, to dropping weights, and to augmenting the regressions with a developing country dummy • Causality is a big issue (Burnside, Eichenbaum, and Rebelo, 2001) • IV regressions confirm the results but instrument (SIZE) is lousy • We tried to go in the other direction. OSIN on the left and LYS on the right instrumented with openness. We found no correlation between LYS and OSIN • Using lagged OSIN in a panel confirms the results • Devereux and Lane (2003)

  18. Original Sin, Output and Capital Flow Volatility • Original sin limits the scope and effectiveness of counter-cyclical policies (Cespedes, Chang and Velasco, 2003) • Original Sin limits the CB ability of acting as a LOLR (Chang and Velasco, 2000) • Dollar liabilities are likely to increase the cost of a currency crisis • Dollar liabilities could be associated with Sudden Stops in capital flows (Calvo, Izquierdo and Mejia, 2003)

  19. Original Sin, Output and Capital Flow Volatility (1) (2) (3) (4) Dropping Financial Centers VOL_GROWTH VOL_FLOW VOL_GROWTH VOL_FLOW OSIN3 0.011 7. 103 0.015 7.498 (1.96)* (3.58)*** (2.45)** (2.69)** LGDP_PC - 0.012 - 3.214 - 0.012 - 3.322 (2.14)** (2.56)** (2.09)** (2.40)** OPEN - 0.001 - 4.181 - 0.000 - 4.333 (0.12) (1.20) (0.08) (0.83) VOL_TOT - 0.000 0.223 - 0.000 0.223 (0.86) (1.08) (0.89) (1.02 ) SHARE2 - 0.014 0.147 - 0.015 0.949 (1.72)* (0.04) (1.51) (0.14) Constant 0.135 32.825 0.131 33.282 (2.25)** (2.39)** (2.15)** (2.22)** Observations 77 33 73 29 R - squared 0.40 0.64 0.40 0.62

  20. Original Sin and Credit Ratings • If a country’s debt is denominated in foreign currency, its capacity to pay will not be related to its LCU GDP but to its dollar GDP • Original Sin makes the real exchange rate matter for debt service • This is important because in developing countries the volatility of dollar GDP is much higher than the volatility of LCU GDP, and sudden drops of dollar GDP are usually associated with much smaller drops in real GDP • Other things equal, countries with Original Sin should be riskier than countries that borrow in own currency

  21. Original Sin and Credit Ratings (1) (2) (3) (4) RATING RATING RATING RATING Dropping Financial Centers OS IN3 - 5.845 - 5.644 - 5.214 - 4.955 (4.08)*** (4.01)*** (3.31)*** (3.21)*** DE_GDP - 2.421 - 2.285 (2.50)** (2.32)** DE_RE - 0.999 - 0.975 (2.49)** (2.39)** LGDP_PC 2.916 2.670 2.976 2.729 (8.48)*** (6.16)*** (8.36)*** (5.97)*** SHARE2 2.187 2. 787 1.810 2.405 (1.43) (1.52) (1.09) (1.18) Constant - 8.058 - 5.962 - 9.119 - 7.037 (2.12)** (1.28) (2.29)** (1.44) Observations 56 49 53 46

  22. The Mystery of Original Sin (the causes)

  23. Key Question from this Point of View • Does the inability to borrow internationally in domestic currency reflect problems with country policies and institutions or systematic problems? • We argue that the problem is too pervasive (and too weakly correlated with country characteristics) to be entirely explicable on the first set of grounds.

  24. Five possible explanations • Underdevelopment of institutions and policies in general • Inadequate monetary credibility • Fiscal profligacy • Weak contract enforcement • Political economy stories

  25. Original Sin and the Level of Development (1) (2) (3) OSIN3 OSIN3 OSIN3 LGDP_PC - 0.141 - 0.128 - 0.170 (1.59) (1.43) (2.99)*** SIZE - 0.310 - 0.310 - 0.415 (3.37)*** (3.33)*** (4.51)*** FIN_CENTER - 0.680 (1.99)* EUROLAND - 0.126 - 0.152 (0.62) (0.74) OTH_DEVELOPED 0.007 - 0.021 (0.03) (0.10) Constant 2.522 2.414 2.833 (3.39)*** (3.24)*** (5.46)*** Observations 75 71 75

  26. Original Sin and Monetary Credibility • Lack of monetary credibility is the true cause of Original Sin (Jeanne, 2002) • The government has an incentive to inflate away domestic currency debt held by foreigners, and the presence of foreign currency debt can act as commitment device and improve credibility (Tirole, 2002, Calvo and Guidotti, 1990) • Why don’t we observe inflation indexed debt? (Chamon, 2002)

  27. Original Sin and Monetary Credibility (1) (2) (3) (4) (5) (6) Dropping Financial Centers OSIN3 OSIN3 OSIN3 OSIN3 OSIN3 OSIN3 AV_INF 0.306 0.436 (1.19) (0.69) AV_INF2 - 0.116 (0.23) MAX_INF 0.067 (0.95) INF 0.085 0.083 0.175 (1.09) (1.07) (2.08)** SIZE - 0.318 - 0.318 - 0.316 - 0.318 - 0.318 - 0.503 (3.57)*** (3.54)*** (3.52)*** (3.55)*** (3.50)*** (5.75)*** FIN_CENTER - 0.866 - 0.897 - 0.857 - 0.881 (2.88)*** (2.99)*** (2.83)*** (2.93)*** EUROLAND - 0.304 - 0.329 - 0.296 - 0.315 - 0.318 (2.12)** (2.31)** (1.99)* (2.21)** (2.21)** OTH_DEVELOPED - 0.199 - 0.224 - 0.192 - 0.211 - 0.213 (1.47) (1.67)* (1.37) (1.56) (1.57) Constant 1.277 1.310 1.259 1.346 1.347 1.358 (10.87)*** (11.60)*** (8.83)*** (13.56)*** (13.46)*** (13.41)*** Observations 74 74 74 74 70 74

  28. KOR MEX IND SWE THA TUR NOR SGP AUT ISR IDN FIN PHL VEN CHL COL HUN BEL PAK GRC MAR DNK SVN TUN POL BGR URY DOM LKA OMN NET CRI GTM JOR SLV ESP BHR ZWE ECU ISL SVK CYP CAN JAM EST MLT BOL MUS LVA PNG BHS AUS MDA BRB GBR SUR FRA ZAF PRT TTO USA JPN DEU ITA CHE CZE LUX Original Sin and Monetary Credibility .363081 RUS ARG UKR P ER ROM NIC e( OSIN3 | X) - .893699 - .246179 1.48963 e( AV_INF | X )

  29. Original Sin and Monetary Credibility • Low inflation seems to be a necessary but not sufficient condition for escaping Original Sin • Results are robust to longer lags (1970s) • They are robust to instrumenting inflation with an index of CB independence

  30. Original Sin and Fiscal Solvency • A government with weak fiscal accounts has an incentive to debase its currency in order to erode the value of its real obligations (Lucas and Stokey, 1983) • Corsetti and Mackowiack (2002) find that there is a vicious circle in which, in the presence of weak public finances, a large stock of foreign currency debt limits the ability to borrow in domestic currency

  31. - 0.350 - 0.327 - 0.354 - 0.342 - 0.345 - 0.330 - 0.555 (3.71)*** (3.52)*** (3.51)*** (3.42)*** (3.40)*** (3.60)*** (5.92)*** FIN_CENTER - 0.825 - 0.926 - 0.816 - 0.839 - 0.645 (2.72)*** (3.09)*** (2.57)** (2.66)** (2.01)** EUROLAND - 0.3 44 - 0.361 - 0.327 - 0.348 - 0.348 - 0.155 (2.61)** (2.66)*** (2.22)** (2.48)** (2.46)** (0.84) OTH_DEVELOPED - 0.275 - 0.215 - 0.245 - 0.272 - 0.272 - 0.094 (2.18)** (1.54) (1.73)* (2.01)** (1.99)* (0.53) Constant 1.426 1.311 1.370 1.382 1.385 1.260 1.374 (11.99)* ** (11.46)*** (10.06)** (12.04)*** (11.93)*** (8.00)*** (11.66)*** * Observations 64 74 57 57 54 64 64 Original Sin and Fiscal Solvency (1) (2) (3) (4) (5) (6) (7) OSIN3 OSIN3 OSIN3 OSIN3 OSIN3 OSIN3 OSIN3 DE_GDP - 0.073 0.050 (0.50) (0.31) DEFICIT 1.777 (0.92) DE_RE 0.014 (0.24) FISC - 0.025 - 0.024 (0.30) (0.28) DE_GDP*DEV 0.247 (0.88) DE_ GDP*IND - 0.186 (1.13) SIZE

  32. Original Sin and Contract Enforcement • Investors are reluctant to lend in countries where the institutions designed to enforce their claims are weak • Chamon (2002) and Aghion, Bacchetta and Banerjee (2001) show that if depreciation and default risk are correlated and, if in case of default, assets are divided among creditors in proportion to their nominal claims, domestic currency market will disappear • This problem could be solved if courts could enforce complicated contracts that distinguish among creditors of different seniority

  33. Original Sin and Contract Enforcement (1) (2) (3) OSIN3 OSIN3 OSIN3 RULEOFLAW - 0.050 - 0.053 - 0.182 (0.46) (0.49) (2.33)** SIZE - 0.323 - 0.322 - 0.480 (3.53)*** (3.48)*** (5.32)*** FIN_CENTER - 0.883 (2.65)** EUROLAND - 0.326 - 0.325 (1.81)* (1.79)* OTH_DEVELOP - 0.203 - 0.201 ED (1.03) (1.01) Constant 1.388 1.390 1.486 (13.17)*** (13.08)*** (12.33)*** Observations 75 71 75

  34. Original Sin and Political Economy • Original sin could be due to the absence of a domestic constituency of local currency debt-holders prepared to penalize a government that debase the currency • Tirole (2002) suggests that Original Sin may arise from the government’s inability to commit to protect the rights of foreigners

  35. Original Sin and Political Economy (1) (2) (3) (6) OSIN3 OSIN3 OSIN3 OSIN3 DC_GDP - 0.332 - 0.554 (1.49) (2.99)*** FOR_DOM - 7.289 7.224 (2.15)** (0.86) SIZE - 0.290 - 0.360 - 0.323 - 0.399 (3.22)*** (4.02)*** (3.72)*** (4.47)*** FIN_CENTER - 0.75 3 - 0.843 - 0.895 (2.40)** (3.02)*** (3.23)*** EUROLAND - 0.226 - 0.301 - 0.299 (1.37) (2.34)** (2.42)** OTH_DEVELOPED - 0.224 - 0.223 - 0.254 (1.75)* (1.86)* (2.16)** Constant 1.521 1.431 1.291 1.636 (10.13)*** (13.76)*** (11.15)*** (11.32)*** Observations 74 73 72 74

  36. Digression on Domestic Original Sin • It may be the case that the previous regressions do not yield any result because we are not able to measure the “real” size of the domestic local currency market • This would require building a measure of domestic original sin and looking at how it relates to international original sin

  37. + + FC DST DLTII = DSIN + + + + FC DST DLTII DLTIP DLT Digression on Domestic Original Sin • We were able to build such a measure for a small sample of 21 developing countries

  38. Digression on Domestic Original Sin DSIN=0.25+0.37*OSIN3 p value on slope coefficient 0.11 R2=0.13 N= 21 ARG IDN MYS VEN TUR 1 BRA MEX EGY .75 HKG CZE CHL .5 DSIN2 PHL POL HUN ISR SGP .25 THA SVK ZAF IND TWN 0 0 .25 .5 .75 1 OSIN3

  39. (1) (2) (3) (4) (5) (6) (7) ( 8 ) DSIN DSIN DSIN DSIN DSIN DSIN DSIN DSIN LGDP 0.134 (1.63) LGDP_PC 0.029 (0.36) AV_INF 0.134 0.176 0.215 (2.16)** (1.73) (3.75)*** RULEOFLAW - 0.142 (1.59) DC_GDP - 0.638 - 0.263 (1.94)* (0.60) CAPCONTR - 0.069 - 0.140 Digression on Domestic Original Sin (1.18) (3.24)*** Constant - 0.064 0.335 0.217 0.607 0.906 0.218 0.576 0.008 (0.17) (0.49) (1.09) (6.38)*** (4.39)*** (0.43) (7.48)*** (0.04) Observations 21 21 21 20 18 18 21 21 R - squared 0.09 0.01 0.15 0.08 0.18 0.28 0.07 0.37

  40. Digression on Domestic Original Sin TUR ARG IDN MYS 1 VEN CC=0.50 BRA Not significantly different MEX EGY .75 CC=0.69 HKG CZE CHL .5 DSIN2 CC=0.45 PHL POL HUN ISR SGP .25 THA SVK ZAF IND TWN 0 0 .25 .5 .75 1 OSIN3

  41. Digression on Domestic Original Sin • There is some (weak) evidence that capital controls may help in reducing domestic original sin • However, it looks as if capital controls are bad for for international original sin

  42. Back to International Original Sin

  43. Putting Everything Together (1) (2) (3) ( 4 ) ( 5 ) OSIN OSIN OSIN OSIN OSIN SIZE - 0.302 - 0.325 - 0.326 - 0.352 - 0.374 (3.32)*** (3.48)*** (3.50)*** (3.88)*** (4.05)*** GDP per cap - 0.262 - 0.127 - 0. 248 - 0. 113 (2.08)** (1.31) (2.30)** (1.82)* AV_INF 0.288 0.150 0.070 0.274 0.099 (0.89) (0.4 9) (0.29) (0.88) (0.36) DE_GDP - 0.003 - 0.102 0.044 - 0.002 - 0.062 (0.02) (0.60) (0.26) (0.01) (0.37) 0.255 RULE of LAW 0.305 0.091 (1.61) (1.88)* (0.70) - 0.291 DC_GDP - 0.313 - 0.173 - 0.403 -0.269 (1.25) (1.05) (0.59) (1.38) (1.14) FIN_CENTER - 0.492 - 0.453 - 0.680 (1.45) (1.31) (2.06)** EUROLAND 0.032 0.010 - 0.220 (0.15) (0.04) (1.18) OTH_DEVEL. - 0.053 0.030 - 0.299 (0.24) (0.14) (1.55) Constant 3.506 2.505 1.516 3.437 3.437 (3.54)*** (3.22)*** (7.66)*** (4.03)*** (4.03)*** Observations 63 63 63 63 63

  44. SIZE always significant • When we include one variable at a time, we find that: • If we control for country groups there is no other variable that is significantly correlated with Original Sin • If we do not control for country groups, GDP per capita, inflation, rule of law, and size of the financial system are correlated with Original Sin • When we jointly test all the hypotheses, we find that: • When country groups are included, only SIZE is robustly correlated with Original Sin • When country groups are dropped, GDP per capita is marginally significant

  45. Original sin is not merely a problem of country policies (one need not deny the relevance of these, of course) • It is also a problem with the operation of the international system • In a world with transaction costs and decreasing returns to diversification, the global portfolio may have a limited number of currency • If larger countries offer better opportunity for diversification, country size will matter in the choice of the global portfolio • Redemption therefore requires international action to overcome the inertia in the system

  46. Lessons from outliers • An interesting fact about the international issuance of bonds in exotic currency is that it is mostly done by non-residents who then swap the debt-service obligation back to US dollar

  47. Share of local currency international debt issued by non-residents 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Czech South New Poland Hong Kong Denmark Canada Singapore Australia Republic Africa Zealand

  48. Lessons from outliers • An interesting fact about the international issuance of bonds in exotic currency is that it is mostly done by non-residents who then swap the debt-service obligation back to US dollar • They do this to reduce cost of funding • But, why is this complex operation cheaper than borrowing directly in dollar? • A possibility is that the market values the possibility of separating currency and credit risk • The IFIs have a natural hedge and could play a role in expanding this market

  49. Conclusions • Original Sin is a widespread phenomenon • It has costs • Limits the ability to conduct monetary policy • Increases volatility • Increases credit risk • It cannot be easily explained by weak policies or institutions • Country size seems to be important • The IFIs could play a role in reducing Original Sin

  50. The Pain and the Mystery of Original Sin Barry Eichengreen Ricardo Hausmann Ugo Panizza

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