to Eliminate Original Financial Sin
Despite the best efforts of the international
financial architects, the problem of emerging market crises is not going away.
When a country is hit by a piece of bad news or a bout of political
uncertainty - as Brazil was recently - investors sell off their assets and the
currency plummets. If this were all that happened, the main effect would be
more competitive exports and the crisis would solve itself. But since so much
of emerging-market debt is denominated in foreign currency, this produces a
massive increase in debt-servicing costs. Fears of payment difficulties create
a vicious circle.
The core of this phenomenon is that countries cannot borrow abroad in their
own currency: external debt is overwhelmingly denominated in foreign currency.
In the period 1999-2001 developing countries accounted for 8 per cent of the
debt but less than 1 per cent of the currency denomination.
Some would say this is so because the policies and institutions of many
countries lack credibility. But this phenomenon is not peculiar to developing
countries with weak policies and institutions. It affects virtually all
countries except the issuers of the five main currencies. It affects countries
with low inflation, balanced budgets and a reliable rule of law. Since it is
not clear what countries have done to bring this problem upon themselves, it
is referred to as "original sin".
What accounts for the concentration of the world's debt portfolio in a few
currencies? For countries to be able to borrow abroad in local currency, the
foreign investor - the proverbial Belgian dentist - must take a long posi tion
in local currency. But it is hard to imagine the dentist managing a port-folio
that includes the currencies of many small economies. Each additional currency
adds an opportunity for diversification but it also adds costs and risks. The
optimal portfolio will thus have a limited number of currencies.
Countries consequently face an uphill battle when seeking to add their
currencies to the global basket. Those that succeed will make it harder for
competitors: investors will have even less appetite for additional exotic
currencies. Thus, the problem of original sin is not merely a problem of
inadequate national policies. It is a problem with the international system
that requires an international solution.
We propose a unit of account - the EM index - based on a diversified set of
emerging-market and developing-country currencies. This unit would represent
claims on a more diversified economy and hence would be more stable, since
shocks such as changes in export prices that are positive for some economies
will be negative for others. Each currency in the basket would be indexed to
the country's inflation rate to protect investors from the borrower's
temptation to debase it. Historically, this basket has shown low volatility,
making it attractive to investors.
The World Bank and the other international financial institutions (IFIs)
should start issuing debt in the EM index. Their AAA rating allows them to
access institutional investors and should create sufficient liquidity to make
the bonds easily tradable.
The IFIs will find it easy to get rid of the currency mismatch caused by
issuing EM-indexed bonds. They can simply convert the dollar loans they have
made to the countries in the index into local currency CPI-indexed loans. They
will thereby eliminate the currency mismatch generated through their own
lending, and become a solution for instead of a source of original sin.
Other high-grade issuers will then be able to develop the market further. The
governments that issue the five main currencies are the natural candidates to
issue additional high-grade EM-indexed debt. They too are low-risk, AAA-rated
borrowers. And they have an interest in eliminating the global instability
created by original sin.
Of course, the industrial countries will not want to expose themselves to a
currency mismatch. They will want to swap their currency exposure with the
emerging markets. But, precisely by doing so, they will allow the EMs to
offload their currency risk. In fact, it has been through foreign issuers -
mainly IFIs - and the swap market that a few lucky countries such as Poland,
South Africa and New Zealand have escaped original sin.
The standard recipe of macro-economic prudence and institution-building will
not do away with original sin any time soon but promoting the EM index market
could do it.
The writers are professors of economics at Berkeley and Harvard
Hausmann bio page)