Original Sin The Pain, the Mystery And the Road to Redemption

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 IIIREDEMPTION

3. The global portfolio is highly concentrated by currency

4. The global 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

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

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

7. 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

8. Table 7: Original sin and 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

9. 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

10. 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

11. 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

12. 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. • International transaction costs and heterogeneity • 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. • 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). • 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.

15. 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

16. 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

17. IFIs are very important in the new OS outliers 1993-98 1999-01

18. 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

19. 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

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

21. An alternative route to redemption IFI EM has to pay when the real exchange rate is i D strong, which is often Peso bond when the economy is OK. Performance risk is diminished. Belgian i D i*D* dentist Dollar bond i*D* EM government 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.

22. 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

23. 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

24. 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.

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 • 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

26. 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

27. Expected further developments • If the EM-index market develops, mutual funds and institutional investors will try to add a by buying local currency instruments issued by residents • 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 • 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

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