1 Original Sin The Pain, the Mystery And the Road to Redemption Barry Eichengreen, Ricardo Hausmann & Ugo Panizza UC Berkeley, Harvard, and IDB

2 PART III REDEMPTION

The global portfolio is highly concentrated by currency

4 The global portfolio United StatesEUROLANDJapanU.KSwitzerlandCanadaAustralia Debtby Country Debtby Currency (0.9857) (0.8859)

5 Major Financial Centers (61 %) Major Financial Centers (45 %) Euroland (37%) Euroland (33%) Other Developed (<2%) Other Developed (8%) Developing (8%) International Organizations (7%) Total Debt issued in own currency (99-01) Total Debt issued by residents (99-01)

6 This is bad Makes stabilization policy less effective Makes stabilization policy less effective Makes bad shocks more destabilizing Makes bad shocks more destabilizing Think of Brazil, Thailand, Indonesia Think of Brazil, Thailand, Indonesia It increases volatility of output and capital flows It increases volatility of output and capital flows Lowers credit ratings controlling for other fundamentals Lowers credit ratings controlling for other fundamentals

7 Table 6: Original sin and exchange rate flexibility (1) (2) (3) LYS RESM2 RVER OSIN (2.98)*** (3.74)*** (2.02)** LGDP_PC (3.61)*** (1.85)* (0.61) OPEN (1.85)* (0.41) (2.88)*** SHARE (0.46) (0.66) (2.36)** Constant (1.79)* (1.73)* (0.17) Observations R-squared

8 Table 7: Original sin and volatility (1) (2) VOL_GROWTH VOL_FLOW OSIN (1.96)* (3.58)*** LGDP_PC (2.14)** (2.56)** OPEN (0.12) (1.20) VOL_TOT (0.86) (1.08) SHARE (1.72)* (0.04) Constant (2.25)** (2.39)** Observations R-squared

9 The Weak Relationship Between Debt/GDP and Credit Ratings rating foreign currency net_debt/gdp ARG AUS AUT BEL BRA CAN CHN CRI CYP CZE DNK DOM EST FIN DEU GRC HUN ISL IND ISR ITA JPN JOR LVA MEX MAR NOR PAK PAN PRY POL PRT SVN ESP SWE TTO TUN TUR GBRUSA

10 Debt to tax ratios do remarkably poorly as predictors of ratings credit rating average DE_RE ARG AUS AUT BEL BOL BRA CAN CHL CHN COL CRI CYP CZE DNK DOM SLV EST FIN DEU GRC HUN ISL IND IDN ISR ITA JORKAZ KOR LVA LUX MLT MEX MNG MAR NOR PAN PRY PER POL SGP SVK SVN ZAF ESP SWE CHE THA TUN TUR GBRUSA

11 Table 8: Original sin and credit ratings (1) (2) (3) (4) RATING1 DE_GDP (1.91)* (2.19)** DE_RE (1.40) (1.52) LGDP_PC (8.54)*** (7.59)*** (6.47)*** (5.68)*** OSIN (3.85)*** (3.49)*** (3.11)*** Constant (3.16)*** (2.60)** (1.89)* (1.57) Observations R-squared

It cannot be explained by weak domestic policies and institutions Too many good guys suffer from it

13 Why Might a Few Important Currencies So Dominate the Global Portfolio? Additional currencies add decreasing diversification benefits but constant transaction costs. Additional currencies add decreasing diversification benefits but constant transaction costs. International transaction costs and heterogeneity International transaction costs and heterogeneity Network externalities may give a small number of vehicle currencies special attraction. Network externalities may give a small number of vehicle currencies special attraction. Countries seeking to add their currencies to the global portfolio thus face an uphill battle. Countries seeking to add their currencies to the global portfolio thus face an uphill battle. And each that succeeds makes life tougher for the others. And each that succeeds makes life tougher for the others.

14 Bottom Line Original sin is not merely a problem of country policies (one need not deny the relevance of these, of course). 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 (given transactions costs, a world of heterogeneous countries, and network effects that lock in the status quo). It is also a problem with the operation of the international system (given transactions costs, a world of heterogeneous countries, and network effects that lock in the status quo). Redemption therefore requires international action to overcome the inertia in the system. Redemption therefore requires international action to overcome the inertia in the system.

15 Lessons from outliers Countries that have recently escaped original sin seem to have done so through non-nationals issuing debt in domestic currency 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 IFIs have played a major role in this process Borrowers swap their obligations with residents Borrowers swap their obligations with residents

16 Foreigners issue most of the debt in exotic currencies Czech Republic South Africa New Zealand PolandHong Kong DenmarkCanadaSingaporeAustralia OSIN 3 % Foreign Countries with OSIN 3 below 0.8, excluding Financial Centers

17 IFIs are very important in the new OS outliers

18 Our proposal We propose an index based on an inflation-adjusted basket of EM currencies 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 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 We propose that the WB, other IFIs and C-5 governments issue debt in this index and swap obligations with EMs

19 Why is this so? Not because of a “developmental” goal Not because of a “developmental” goal IDB issued in non-member currencies IDB issued in non-member currencies Only because it is cheaper Only because it is cheaper Swap back into US$ Swap back into US$ What makes it more efficient? What makes it more efficient? Correlation between currency risk and default risk makes local instruments inefficient Correlation between currency risk and default risk makes local instruments inefficient IFIs have no correlation between currency and default risk 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 Local borrowers on the other end pay to get rid of the mismatch enough to encourage IFIs to issue

20 An “ideal” world without OS Belgian dentist IFI EM government Peso bond Dollar bond i D i*D* The Belgian dentist would hold both the riskless IFI bond plus the currency, the credit risk and the covariance term between the two.

21 An alternative route to redemption Belgian dentist IFI EM government Peso bond Dollar bond i*D*i D i*D* The Belgian dentist now holds the currency risk in the IFI bond and the credit risk, in the EM bond, but these are not correlated anymore. EM has to pay when the real exchange rate is strong, which is often when the economy is OK. Performance risk is diminished.

22 Our proposal Develop an index Develop an index based on a basket of currencies based on a basket of currencies Indexed to inflation Indexed to inflation GDP PPP weighted GDP PPP weighted We show that it has three characteristics We show that it has three characteristics Trend appreciation Trend appreciation Low volatility: very diversified Low volatility: very diversified Negative correlation with consumption in industrial countries Negative correlation with consumption in industrial countries Excellent for a developed country portfolio Excellent for a developed country portfolio

Q11981Q11982Q11983Q11984Q11985Q11986Q11987Q11988Q11989Q11990Q11991Q11992Q11993Q11994Q11995Q11996Q11997Q11998Q11999Q12000Q12001Q1 20 in the 80's 22 from DM Index Yen Index The EM is a stable index

24 Appreciation, stability, risk diversification 1 Note: Correlations with Real Consumption: for France, Germany, Italy and Spain it covers For Canada, UK, US and Japan it covers A negative number indicates that the returns tend to be high when real private consumption is low.

25 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 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 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 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 Regional IFIs can swap with the WB or the governments themselves for non-regional index members WB would calculate index lowering manipulation risk WB would calculate index lowering manipulation risk

26 Step 3. Have C-5 countries issue debt denominated in index Also high-grade non-residents with an interest in lowering global risks Also high-grade non-residents with an interest in lowering global risks Swap currency exposure with EM-member countries Swap currency exposure with EM-member countries This gets read of the mismatch This gets read of the mismatch Need not cost them anything Need not cost them anything Make sure by providing put-option on the price of the swap 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 The swap is much safer than sovereign risk and can be made safer

27 Expected further developments If the EM-index market develops, mutual funds and institutional investors will try to add  by buying local currency instruments issued by residents If the EM-index market develops, mutual funds and institutional investors will try to add  by buying local currency instruments issued by residents Evidence from exotic currencies is that IFI role dwindles in time as market develops Evidence from exotic currencies is that IFI role dwindles in time as market develops

28 In conclusion We base our solution on the experience of outliers We base our solution on the experience of outliers Role of foreign issuers, IFIs, swaps Role of foreign issuers, IFIs, swaps We address the cause of OS by offering a well diversified synthetic currency We address the cause of OS by offering a well diversified synthetic currency We address the credibility problem of EMs by indexing to inflation We address the credibility problem of EMs by indexing to inflation Very limited downside risk if attempt to develop EM market fails Very limited downside risk if attempt to develop EM market fails

29 Original Sin The Pain, the Mystery And the Road to Redemption Barry Eichengreen, Ricardo Hausmann & Ugo Panizza UC Berkeley, Harvard, and IDB