Up From Sin: A Portfolio Approach to Financial Salvation Randall Dodd, Financial Policy Forum Shari Spiegel, Initiative for Policy Dialogue (IPD), Columbia University U.N. Financing for Development World Economic Forum June 22, 2005

IDENTIFYING FINANCING PROBLEM AND POLICY REMEDY PROBLEM 1. Developing countries face too much foreign exchange risk from foreign debt denominated in US dollar and other major currencies Most financial crisis linked to currency devaluation 2. Original Sin: developing countries cannot borrow abroad in their own currency – or so we thought 3. Foreign investors unwilling to hold exchange rate risk on highly volatile developing country currencies 4. Hedging local currency risk through use of derivatives prohibitively expensive SOLUTION 1. Invest in local currencies through diversified portfolio 2. Diversification is effective because of low degree of correlation between rates of return on local currency assets 3. Diversification – the only real free lunch in financial economics – allows investors to earn high returns on portfolio whose variance is low due to low and sometimes negative correlation 4. Promote the use of such investment strategies by international investors and international financial institutions. Support the development of local currency and Treasury security markets by developing country governments.

Emerging Market Local Currency Debt Portfolio The historical risk profile of an Equally Weighted Emerging Market Local Currency Debt (EMLCD) portfolio (WITH MAJOR CURRENCY RISK HEDGED) provides better risk adjusted returns, with a Sharpe Ratio of.9 *Returns are from January 1994 to January ¹EMLCD: data based on equal country weightings. Except for countries with liquidity restrictions, which were limited to 1% weightings. Major currency (USD/EURO, YEN/USD) risk is hedged. Annualized Return and Risk since January 1993* EMLCD Universe¹ JP Morgan Emerging Market Bond Index (EMBI) MSCI Emerging Market Equity Free Index Annual Return (%) Annual Volatility (%)

Local Currency Debt – A Good Diversifier The portfolio has very little correlation with other financial assets. *Correlations of monthly returns for the period 1/93 - 9/01 U.S. High Grade: Lehman Brothers Aggregate Index U.S. High Yield: Lehman Bros. B-Rated High Yield Index U.S. Equity: Standard & Poors 500 Index WGBI (US$ hgd): Salomon Bros. NonUS World Gov’t Bond Index (Hedged) Brady Bonds: Salomon Brady Bond Index Emerging Equity: MSCI Emerging Market Free Index EMLCD: data compiled from study based on equal country weightings. Except for countries with liquidity restrictions, which were limited to 1% weightings. Major currency (USD/EURO, YEN/USD) risk is hedged.

Histogram of Monthly Total Returns Annualized Return9% Annualized Standard Deviation16% Data from Jan 1994 – Jan 2004

Histogram of Portfolio Returns (Equally Weighted Countries) Annualized Return: 9% Annualized Standard Deviation: 5.3% Worst Monthly Case: -4.3% Data from Jan 1994 – Jan 2004

POLICY ISSUES For Developing Countries BENEFITS of Portfolio Approach 1. Reduce foreign currency exposure 2. Develop and deepen local financial markets Countries can initiate local market improvements and/or issue internationally Price discovery – create a yield curve for pricing future events Liquidity Auctions can replace underwriting costs 3. Simple, flexible and cheap 4. Seigniorage – more local currency transactions generate more use of currency and in turn more seigniorage COSTS 1. Higher nominal interest rates than dollar debt 2. Exposure to capital flight LIMITATIONS 1. Maturity

For Investors BENEFITS of Portfolio Approach 1. High Sharpe ratio – risk adjusted rate of return 2. Investment returns that are uncorrelated with developed country returns COSTS 1. High transactions costs 2. High initial investment needed to overcome high fixed transaction costs 3. High minimum investment needed to achieve sufficient diversification POLICY ISSUES

REMEDY THROUGH ABS STRUCTURE BENEFITS of Asset Back Security Structure 1. Gains from specialization in managing transactions costs 2. Lower minimum investment thresholds for diversification 3. Lower transactions costs 4. More liquid 5. Longer-term commitment COSTS 1. Underwriting (instead of auction) 2. Contribute less to development and deepening of local financial markets POLICY ISSUES

UNANSWERED QUESTIONS 1. What is the best index associated for local currency assets? 2. How to handle partial diversification for regional investment or as temporary process in the building of a fully diversified portfolio? 3. What is the best structure for a new issue? Should it include tranches for risk? POLICY ISSUES

Up From Sin: A Portfolio Approach to Financial Salvation Randall Dodd, Financial Policy Forum Shari Spiegel, Initiative for Policy Dialogue (IPD), Columbia University U.N. Financing for Development World Economic Forum June 22, 2005