Original sin redux: a model-based evaluation

Summary

Focus

Having developed and deepened their local currency sovereign bond markets, many EMEs can now routinely borrow from abroad in their own currency. However, overcoming "original sin" – the traditional necessity of borrowing in dollars or another foreign currency – has not led to "redemption". As foreign investors still play an important role in their local currency bond market, EMEs remain vulnerable to capital flow and exchange rate swings. And this gives rise to "original sin redux".

Contribution

This paper provides a model-based evaluation of the original sin redux hypothesis based on a two-country model. We explore the channels through which original sin redux arises, the differences to the traditional original sin of borrowing in foreign currency from abroad, and the policy implications for EMEs.  

Findings

The main findings are, first, borrowing from abroad in local currency falls short of eliminating the vulnerability of EMEs to foreign financial shocks, although it does reduce it. Second, additional macro-financial stability policy tools, such as FX intervention, can mitigate the challenges from capital flow swings in an original sin redux scenario. Third, in the longer run, a larger domestic investor base could reduce the vulnerability of EMEs to capital flow swings. Finally, local currency external borrowing and a larger domestic investor base strengthen the transmission of domestic monetary policy in EMEs, thus providing EME central banks with more policy traction.

Abstract

Many emerging markets (EMs) have graduated from "original sin" and are able to borrow from abroad in their local currency. Using a two-country model, this paper shows that the shift from foreign currency to local currency external borrowing does not eliminate the vulnerability of EMs to foreign financial shocks but instead results in "original sin redux" (Carstens and Shin (2019)). Even under local currency borrowing from foreign lenders, a monetary tightening abroad is propagated to EM financial conditions through a tightening of foreign lenders' financial constraints. Moreover, local currency borrowing does not eliminate currency mismatches, but shifts them from the balance sheets of EM borrowers to the balance sheets of financially constrained global lenders, so that amplifying financial effects of exchange rate fluctuations remain. We provide empirical evidence in line with this prediction of the model using data on currency composition of external debt of emerging and advanced economies. Our model-based analysis further suggests that foreign exchange intervention and capital flow management measures can mitigate the adverse effects of capital flow swings in the short run and that a larger domestic investor base can reduce the vulnerability to such swings in the longer run.

JEL classification: E3, E5, F3, F4, F6, G1.

Keywords: emerging market, capital flows, exchange rate, currency mismatch.