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OTHER PEOPLE'S MONEY Debt Denomination and Financial Instability in Emerging Market Economies
The University of Chicago Press Copyright © 2005 The University of Chicago
All right reserved. ISBN: 978-0-226-19455-4
Chapter One The Pain of Original Sin Barry Eichengreen, Ricardo Hausmann, and Ugo Panizza
If a country is unable to borrow abroad in its own currency-if it suffers from the problem that we refer to as "original sin"-then when it accumulates a net debt, as developing countries are expected to do, it will have an aggregate currency mismatch on its balance sheet. Of course, such a country can take various steps to eliminate that mismatch or prevent it from arising in the first place. Most obviously, it can decide not to borrow. A financially autarchic country will have no currency mismatch because it has no external debt, even though it still suffers from original sin as we define it. But this response clearly has costs; the country in question will forgo all the benefits, in the form of additional investment finance and consumption smoothing, offered by borrowing abroad. Alternatively, the government can accumulate foreign reserves to match its foreign obligations. In this case the country eliminates its currency mismatch by eliminating its net debt (matching its foreign-currency borrowing with foreign-currency reserves). But this too is costly: the yield on reserves is generally significantly below the opportunity cost of funds.
All of this might seem relatively inconsequential. The currency denomination of the foreign debt has not, until recently, figured prominently in theories of economic growth and cyclical fluctuations. Macroeconomic stability, according to conventional wisdom, reflects the stability and prudence of a country's monetary and fiscal policies. The rate of growth of per capita incomes depends on rates of human and physical capital accumulation and on the adequacy of the institutional arrangements determining how that capital is deployed. Fine points like the currency in which a country's foreign debt is denominated, by comparison, are regarded as specialized concerns of interest primarily to financial engineers.
In this chapter we show that neglect of this problem constitutes an important oversight. In particular, we show that the composition of external debt-and specifically the extent to which that debt is denominated in foreign currency-is a key determinant of the stability of output, the volatility of capital flows, the management of exchange rates, and the level of country credit ratings. We present empirical analysis demonstrating that this "original sin" problem has statistically significant and economically important implications, even after controlling for other conventional determinants of macroeconomic outcomes. We show that the macroeconomic policies on which growth and cyclical stability depend, according to conventional wisdom, are themselves importantly shaped by the denomination of countries' external debts.
Establishing the importance of original sin for the macroeconomic outcomes of interest requires a precise measure of the phenomenon. Indeed, one reason that the problem of debt denomination has not received the attention it deserves may be that adequate information on its incidence and extent are not readily available. Thus, a contribution of this chapter is to develop a series of numerical indicators of original sin. In addition to demonstrating their importance for the macroeconomic variables relevant to our argument, we present the indicators themselves, country by country, so they can be used by other authors to analyze still other problems.
In the first two sections of this chapter, we quantify the problem and characterize its incidence. The next section analyzes its effects-what we characterize as the pain of original sin. This is followed by a brief conclusion and an appendix where we report the results of a battery of sensitivity analyses and present the underlying indicators.
Facts about Original Sin
Of the nearly US$5.8 trillion in outstanding securities placed in international markets in the period 1999-2001, $5.6 trillion was issued in five major currencies: the U.S. dollar, the euro, the yen, the pound sterling, and the Swiss franc. To be sure, the residents of the countries issuing these currencies (in the case of Euroland, of the group of countries) constitute a significant portion of the world economy and hence form a significant part of global debt issuance. But while residents of these countries issued $4.5 trillion of debt over this period, the remaining $1.1 trillion of debt denominated in their currencies was issued by residents of other countries and by international organizations. Since these other countries and international organizations issued a total of $1.3 trillion of debt, it follows that they issued the vast majority of it in foreign currency. The measurement and consequences of this concentration of debt denomination in few currencies is the focus of this chapter.
Table 1.1 presents data on the currency composition of bonded debt issued cross-border between 1993 and 2001. "Cross-border" means that table 1.1 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 each subperiod. The information is organized by country groups and currencies of denomination. The first country group, financial centers, is composed of the United States, the United Kingdom, 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 (since these turn out to be important below).
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 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 -98, debt denominated in their currencies amounted to 68 percent of that total. In contrast, while other developed countries outside of 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 1 percent of the currency denomination in the 1993-98 period. This, in a nutshell, is the problem of original sin.
When we look at the currency denomination of the debt issued by residents, we see that residents of the major financial centers chose to denominate 68.3 percent of it in their own currency in 1999-2001, while the residents of Euroland used the euro in 56.8 percent of their cross-border bond placements. This figure is substantially higher than the 23.2 percent that they chose to denominate in their own currency in 1993-98, before the introduction of the euro. In that earlier period, the other developed countries issued 17.6 percent of their debt in their own currencies, a number not too different from that for the Euroland countries; in the recent period, however, this number has declined to 9.6 percent. The number for developing countries is an even lower 2.7 percent.
It is sometimes possible for countries to borrow in one currency and swap their obligations into another. Doing so requires, however, that someone actually issue debt in the domestic currency (otherwise there is nothing to swap). Column (8) takes this point on board and is therefore a better measure of a country's ability to borrow abroad in its own currency than column (7), in the sense that when the ratio in column (8) is less than one, it indicates that there are not enough bonds to do the swaps needed to hedge the foreign-currency exposure of residents.
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 percent. (This, in a sense, is what qualifies them as financial centers.) 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 toward the ratios exhibited by developing nations.
Figure 1.1 plots the cumulative share of total debt instruments issued in the main currencies (the solid line) and the cumulative share of debt instruments issued by the largest issuers (the dotted line). The gap between the two lines is striking. While 87 percent of debt instruments are issued in the three main currencies (the U.S. dollar, the euro, and the yen), residents of these three countries issue only 71 percent of total debt instruments. The corresponding figures for the top five currencies, 97 and 83 percent, respectively, tell the same story.
Table 1.2 presents similar information for cross-border claims by international banks reporting to the Bank for International Settlements. These data distinguish only the five major currencies (U.S. dollar, euro, Swiss franc, British pound, and Japanese yen) and an "other currency" category. The table shows that of $7.8 trillion in cross-border bank claims, 81 percent are denominated in the five major currencies. While we cannot know how much is actually issued in each borrower's currency, we can safely say that the bulk of the debt in the developing world and in the developed countries outside the issuers of the major currencies is also in foreign currency.
One possible problem with the data in table 1.1 is that they only capture cross-border bond issuance and do not capture the nationality of the bondholder, only the place of issue. So it may be that countries do their local-currency funding in the local market and their foreign-currency funding abroad. Foreigners willing to hold domestic-currency bonds would just purchase them in the local markets. These domestically issued but foreign-owned domestic-currency bonds would not be included in table 1.1. To address this issue, we look at the currency composition of the international securities held by U.S. residents, independently of the place of issue.
According to the U.S. Treasury (table 1.3), these securities amounted to US$647 billion at the end of 2001. Of these securities, however, US$456 billion or 70.4 percent were denominated in U.S. dollars. This indicates that the willingness of U.S. investors to expose themselves to foreign credit risk is significantly higher than their willingness to expose themselves to foreign-currency risk: they hold more claims on foreigners than claims in foreign currency. Moreover, if we include the exposure to the euro, the yen, the British pound, and the Canadian dollar, the total foreign exposure of U.S. investors denominated in major currencies amounts to 97 percent of the total. In the case of developing countries, while U.S. investors held US$84 billion in securities issued by developing countries, only $2.6 billion (or 3.1 percent) was denominated in local currency. The message of table 1.3 is similar to that of table 1.1: global investors denominate their claims predominantly in very few currencies. The willingness to hold foreign securities is significantly larger than the willingness to hold them in foreign currency, except for a few major currencies.
All this points to the fact that original sin is a global phenomenon. It is not limited to a small number of problem countries. It seems to be associated with the fact that the vast majority of the world's financial claims are denominated in a small set of currencies. In turn this suggests that the problem may have something to do with observed patterns of portfolio diversification-or its absence. We develop this point in chapter 9.
Measuring Original Sin
To construct indexes of original sin, we use the data on securities and bank claims used to construct tables 1.1 and 1.2. We start with the securities data set, which provides a full currency breakdown.
Our first indicator of original sin (OSIN1) is one minus the ratio of the stock of international securities issued by a country in its own currency to the total stock of international securities issued by the country. That is,
OSIN[1.sub.i] = 1 - Securities issued by country i in currency i/ Securities issued by country i.
Thus, a country that issues all its securities in own currency would get a zero, while a country that issues all of them in foreign currency would get a one (the higher the value, the greater the sin). We also compute a variant of OSIN1 by using the data on security holding by U.S. investors (USSIN1).
OSIN1 has two drawbacks. First, it covers only securities and not other debts. Second, it does not take account of opportunities for hedging currency exposures through swaps. We deal with these issues next. Consider the following ratio:
INDEX[A.sub.i] = Securities + Loans issued by country i in major currencies/ Securities + Loans issued by country i.
INDEXA has the advantage of increased coverage. (It also has the disadvantage of not accounting for the debt denominated in foreign currencies other than the majors; we address this problem momentarily). To capture the scope for hedging currency exposures via swaps, we also consider a measure of the form
INDEX[B.sub.i] = 1 - Securities in currency i/ Securities issued by country i.
INDEXB accounts for the fact, discussed above, that debt issued by other countries in one's currency creates an opportunity for countries to hedge currency exposures via the swap market. Notice that this measure can take on negative values, as it in fact does for countries such as the United States and Switzerland, since there is more debt issued in their currency than debt issued by nationals. However, these countries cannot hedge more than the debt they have. Hence, they derive scant additional benefits from having excess opportunities to hedge. We therefore substitute zeros for all negative numbers, producing our third index of original sin:
OSIN[3.sub.i] = max (1 - Securities in currency i/ Securities issued by country i, 0).
We are now in a position to refine INDEXA. Recall that INDEXA understates original sin by assuming that all debt that is not in the five major currencies is denominated in local currency. This may be a better approximation for countries with some capacity to issue debt in their own currencies. If this is so, however, it should be reflected in OSIN3 because it means that someone-either a resident or a foreign entity-might have been able to float a bond denominated in that currency. If this is not the case, this provides information about the likelihood that the bank loans not issued in the five major currencies were denominated in some other foreign currency. We therefore replace the value of INDEXA by that of OSIN3 in those cases where the latter is greater than the former. Hence we propose to measure OSIN2 as
OSIN[2.sub.i] = max(INDEX[A.sub.i], OSIN[3.sub.i]).
Notice that OSIN2 [greater than or equal to] OSIN3 by construction and that, in most cases, OSIN1 [greater than or equal to] OSIN2.
Table 1.4 presents the average of these four indexes for the different country groupings and different parts of the developing world. (The individual country values can be found in appendix table 1A.1.) 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 (fig. 1.2). The lowest values in the developing world are in eastern Europe, while the highest are in Latin America.
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