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The mystery of original sin Article · August 2002

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7 authors, including: Ricardo Hausmann

Ugo Panizza

Harvard University

Graduate Institute of International and Development Studies

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The Mystery of Original Sin Ricardo Hausmann, and Ugo Panizza* July 16, 2002 (This Version March, 2003) Comments Welcome

1.

Introduction

Most countries do not borrow abroad in their own currency and cannot borrow in local currency at long maturities and fixed rates even at home, a fact that Eichengreen and Hausmann (1999) refer to as “Original Sin.” This state of affairs creates financial fragility as countries that suffer from this problem are likely to be characterized by either currency mismatches (because of the

*

Kennedy School of Government, Harvard University, and Research Department Inter-American

Development Bank. Email: [email protected] and [email protected]. We are grateful to the Bank for International Settlements and in particular Rainer Widera and Denis Pêtre for data on currency denomination of foreign debt, J.P. Morgan and in particular Martin Anidjar for data on local markets and Pipat Luengnaruemitchai for data on capital controls. We are also grateful to Barry Eichengreen and Ernesto Stein for very useful collaboration in this project, Kevin Cowan, Marc Flandreau, Eduardo Levy-Yeyati, Nathan Sussman, Jean Tirole, Philip Turner and participants at seminars at Harvard University, the Inter-American Development Bank and the Latin American and Caribbean Economic Association for useful comments. 1

currency composition of the debt) or maturity mismatches (because of the short-term nature of the domestic currency debt). Eichengreen, Hausmann and Panizza (2002) show that countries with original sin exhibit greater output and capital flow volatility, lower credit rating, and limited ability to manage an independent monetary policy.

This paper describes the incidence of the problem and makes an attempt at uncovering its cause. In particular, the paper tackles the following questions: Which countries borrow internationally in their own currency and which do not? Which countries borrow domestically in local currency at fixed rates and long maturities? What economic fundamentals are associated with this behavior?

These questions have become important for the debate on financial crises. On the one hand, exchange rate mismatches associated with liability dollarization can expose balance sheets to serious risks associated with a positive feedback between large real exchange rate depreciations and perceptions of insolvency. On the other hand, reliance on short-term borrowing can expose balance sheets to roll-over risks, especially when the debt is in foreign currency so that the cewntral bank cannot assure its liquidity. Both problems can become self-fulfilling as they generate the potential for multiple equilibria1. The empirical evidence on the ability to borrow abroad in local currency (call it the international dimension of original sin) presented in Hausmann, Panizza and Stein (1999) and in Bordo and

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The Latin American debt crisis of the early 1980s, the Mexican 1994 crisis and the East Asian

crisis of 1997 had clearly a bit of both, as the foreign debt was largely short term and in foreign currency. In Ecuador (1999), Argentina (2001) and Uruguay (2002) the short term foreign currency obligations included the domestic banking system. 2

Flandreau (2001) suggest that the set of countries that actually borrow internationally in their own currency is quite a select group with many usual suspects (e.g., G-3), a few surprises (e.g. Australia, New Zealand, Poland and South Africa) and some interesting no shows (e.g. Austria, Chile, Finland, Ireland, Sweden). The domestic dimension of original sin, i.e. the ability to borrow at long maturities and fixed-rates in local currency in the home market - has received less systematic attention. In this paper we update the data on international original sin and develop indicators for the domestic component.

After describing the phenomenon, we consider a wide range of hypotheses aimed at explaining the determinants of original sin. In particular, we discuss and test seven theories.

The first theory focuses on the importance of institutions for financial markets in particular and more broadly for the level of development. The second theory focuses on monetary credibility and suggests that when monetary credibility is low, interest rates in domestic currency will be high. Firms will be faced with the choice of borrowing in dollars and subjecting themselves to currency risk or opting for the risky strategy of borrowing in very expensive terms domestically (Jeanne, 2002).

The third theory is closesly related to the second and focuses on fiscal solvency. It suggests that countries with weak public finances will have an incentive to debase their currencies. Anticipations of this may cause the market to disappear. Dollarizing the debt or making it very short term eliminates the incentive to do so (Lucas and Stokey 1983, Calvo and Guidotti 1990)

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The fourth theory focuses on credit market imperfections or poor contract enforcement. According to this theory, the domestic-currency debt market may disappear when there is a positive correlation between default and depreciation risk, since this creates a moral hazard problem on the borrower who can expropriate his local currency lenders by taking on more foreign currency debt (Chamon, 2002, Aghion, Bachetta and Banerjee, 2002).

The fifth theory focuses on the choice of exchange rate regime. Countries with a fixed exchange rate should experience much of their nominal volatility in the domestic-currency interest rate, while countries that float will see larger exchange rate volatility. Borrowers would then prefer domestic currency debt in floating rate countries and fixed rate debt in flexible exchange rate countries.

The sixth theory focuses on political economy arguments. According to this theory, when foreigners are the main holders of domestic currency debt, governments will have an incentive to debase their currencies. In this sense, international markets in domestic currency can only arise in presence of a domestic constituency of local currency debt holders.

The seventh theory focuses on international causes, emphasizing the role of economies of scale in liquidity which limit the incentives for diversification. An implication of this theory is that country size matters. Currencies from larger country have an advantage in the international market because the larger size of their economies and currency issues makes them liquid and stable and hence attractive as a component of the world portfolio.

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The paper is organized as follows. Section 2 describes and quantifies the international and domestic dimension of original sin. Section 3 describes and tests the theories outlined above. Section 4 concludes.

2.

What do we know about Original Sin?

The definition of original sin focuses on the inability to borrow long-term in domestic currency (even within the domestic market) and the inability to borrow internationally (even short-term) in domestic currency. The purpose of this section is to describe these two dimensions of Original Sin for a sample of developed and developing countries. Rather than building an aggregate index of Original Sin, we will start by discussing its foreign and domestic components separately and then analyze the relationship between the two components.2

2.1 The International Component of Original Sin

To measure whether a given country is able to borrow internationally in its own currency, we use data on international debt securities from the Bank of International Settlements (BIS). The BIS data set contains information on debt instruments (both long and short-term) disaggregated by nationality of issuer and by currency. We use this data set to build proxies of currency mismatches in the country’s balance sheets that we deem to be associated with the inability of

2

Claessens et al. (2003) build a measure of total original sin (domestic plus international) for

government bonds. Their index assumes that all bonds issued domestically are in domestic currency. 5

countries to borrow internationally in their own currency. In building our Original Sin indexes, we follow Hausmann, Stein and Panizza (2001) but extend their sample from 30 up to 91 countries and update it to the end of 2001. Before describing the indexes of original sin and illustrating their cross-country variation, we want to reiterate the point that the world portfolio of cross-border bonds is composed of very few currencies.

The size of the problem3

Table 1 presents data on the currency composition of bonded debt issued cross-border between 1993 in 2001. (“Cross-border” means that Table 1 excludes local issues.) We split the sample into two periods, demarcated by the introduction of the euro. The figures are the average stock of debt outstanding during in each sub-period. The information is organized by country groups and currencies of denomination. The first country group, financial centers, is composed of the US, the UK, Japan, and Switzerland; the second is composed of the Euroland countries; the third contains the remaining developed countries; and the fourth is made up of the developing countries; we also report data on bond issues by the international financial institutions. Column 1 presents the amount of average total stock of debt outstanding issued by residents of these country groups. Column 2 shows the corresponding percentage composition by country group. Columns 3 and 4 do the same for debt issued by residents in their own currency, while columns 5 and 6 look at the total debt issued by currency, independent of the residence of the issuer. Column 7 is the proportion of the debt that the residents of each country group issued in their own currency (the

3

The discussion in this sub-section is from Eichengreen, Hausmann and Panizza (2002) 6

ratio of column 3 to column 1), while column 8 is the proportion of total debt issued in a currency relative to the debt issued by residents of those countries (the ratio of column 5 to column 1).

Notice that while the major financial centers issued only 34 percent of the total debt outstanding in 1993-1998, debt denominated in their currencies amounted to 68 percent of that total. In contrast, while other developed countries ex-Euroland issued fully 14 percent of total world debt, less than 5 percent of debt issued in the world was denominated in their own currencies. Interestingly, in the period 1999-2001 – following the introduction of the euro – the share of debt denominated in the currencies of other developed countries declined to 1.6 percent. Developing countries accounted for 10 percent of the debt but less than one per cent of the currency denomination in the 1993-1998 period. This, in a nutshell, is the problem of original sin.

Column 8 reveals that in 1999-2001 the ratio of debt in the currencies of the major financial centers to debt issued by their residents was more than 150 per cent.4 This ratio drops to 91.3 percent for the Euroland countries, to 18.8 percent in the other developed countries (down from 32.9 percent in the previous period), and to 10.9 percent for the developing nations. Notice that after the introduction of the euro, Euroland countries narrow their gap with the major financial centers while other developed countries converge towards the ratios exhibited by developing nations.5

4

This, in a sense, is what qualifies them as financial centers.

5

Whenever we observe a drop in Original Sin (this happens for Czech Republic, New Zealand,

Poland, Singapore, Slovak Republic, South Africa, and Taiwan) this always happens because of 7

All this points to the fact that currency mismatches are a global phenomenon. They are not limited to a small number of problem countries. In a sense, the phenomenon seems to be associated with the fact that the vast majority of the world’s cross-border financial claims are denominated in a small set of currencies.

Measuring Original Sin

We measure original sin with two different indicators. Our first indicator of international Original Sin (OSIN1)6 is equal to one minus the ratio between the stock of international securities issued by a country in its own currency and the total stock of international securities issued by the country. Formally:

an increase in the numerator (ie debt issued in domestic currency) and not a drop in the denominator (ie total international debt). 6

This indicator is one minus what Hausmann et al. (2001) call ABILITY1. It should be noted that

we are assuming that countries cannot borrow abroad in their own currency and that our index of original sin captures this inability. However, some countries may not be borrowing abroad because they do not want to. This implies that what we actually observe is the minimum of the ability to borrow in domestic currency and the optimal share of domestic currency debt (i.e., the share of domestic currency debt we would observe if countries were not constrained). Therefore, we are implicitly assuming that the constraint is always binding. As this assumption may be less likely to hold for developed countries, we always check whether the results explain the within country groups variation in original sin. 8

OSIN1i = 1 −

Securities issued by country i in currency i Securities issued by country i

Therefore, a country that issues all its securities in own currency would get a zero and a country that issues al its securities in foreign currency would get a one. This index has two problems. First, it only covers securities and not other debts. Second, it does not take account of opportunities for hedging currency exposures through swaps. To capture the scope for hedging currency exposures via swaps, we use the ratio between international securities issued in a given currency (regardless of the nationality of the issuer) and the amount of international securities issued by the corresponding country. Formally: INDEXBi = 1−

Securities in currency i Securities issued by country i

INDEXB accounts for the fact that debt issued by other countries in one’s currency creates an opportunity for countries to hedge currency exposures via the swap market. Unlike OSIN1, INDEXB can take negative values indicating that the total amount of securities in currency i is larger than the total amount of securities issued by residents of country i. We expect to find negative values for currencies such as the US dollar or the Swiss franc that are commonly used as international store of value. We are interested in INDEXB because if non-residents borrow in a given country’s currency, residents may be able to swap their foreign currency obligations with the domestic currency instruments issued by non-residents and hence fully hedge their currency risk. However, these countries cannot hedge more than the debt they have. Hence, they derive

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scant additional benefits from having excess opportunities to hedge. We therefore substitute zeros for all negative numbers, producing our second index of original sin:7 Securities in currency i   OSIN 3i = max 1 − ,0   Securities issued by country i 

OSIN3 is our favorite measure of Original Sin because, by capturing the possibility of hedging exchange rate risk, it provides an aggregate measure of currency mismatch.

In previous work, we also used an index that covered both bonded debt and bank loans (OSIN2 in Eichengreen, Hausmann and Panizza, 2002). While this index had the advantage of wider coverage, it was a less precise measure of original sin because the currency breakdown of bank loans is only available for the five major currencies. Hence OSIN2 understated original sin by assuming that all debt that is not in the 5 major currencies is denominated in local currency (we addressed this issue by using OSIN3 as a lower bound for OSIN2). In our empirical analysis, we address the issue of coverage by weighing all our regressions by the ratio between total international bonds issued by country i, and total debt (bonds plus loans) issued by country i.

Table 2 presents the average of OSIN1 and OSIN3 for the different country groupings and different parts of the developing world. As before, we observe the lowest numbers for the major financial centers, followed by Euroland countries (which exhibit a major reduction in original sin after the introduction of the euro). Other developed countries exhibit higher values, while the highest values are for the developing world. The lowest values in the developing world are in

7

We call our second index OSIN3 to keep notation consistent with our previous work

(Eichengreen, Hausmann, and Panizza, 2002) 10

Eastern Europe, while the highest are in Latin America. The table also shows that, depending on the region, international bonds represent between one fifth and one half of international debt.

If we move beyond international averages, it is possible to find large differences within groups. Table 3 lists countries that are not financial centers or part of the Euro area and have measures of OSIN3 below 0.8 in 1999-2001. The list includes several future Eastern European accession countries and overseas regions of European settlement (Canada, Australia, New Zealand and South Africa). Notice further that both fixed-rate Hong Kong and floating-rate Singapore and Taiwan appear on this list, raising questions about whether any particular exchange rate regime poses a barrier to redemption.

By comparing OSIN1 with OSIN3, it is possible to identify who are the issuers in a given currency. If OSIN1 is equal to one and OSIN3 smaller than 1, foreign issuers dominate the international market for a given currency. It is interesting to note that, while in the case of OECD countries, national issuers cover a large share of the international issue in domestic currency (reflected by low levels of OSIN1), there is no developing country with a value of OSIN1 that is below 0.95. South Africa and Poland are the countries with the lowest value of OSIN1 (0.95 and 0.96, respectively). This suggests that developing countries escape from Original Sin only thanks to debt issued by foreign investors (captured by OSIN3).

But who are the issuers in the Euromarket for emerging market currencies? J.P. Morgan (2002) points out that the market for paper denominated in Czech and Slovak korunas, Polish zloty, Hungarian forints, and South African rands is dominated by multinationals with high credit rating

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that issue local currency bonds and then swap the proceeds and future repayments into hard c...