Other People’s Money: Debt Denomination and Financial Instability in Emerging Market Economies

Published by EH.NET (November 2005)

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Barry Eichengreen and Ricardo Hausmann, editors, Other People’s Money: Debt Denomination and Financial Instability in Emerging Market Economies. Chicago: University of Chicago Press, 2005. vii + 296 pp. $55 (cloth), ISBN: 0-226-19455-8.

Reviewed for EH.NET by Hans-Joachim Voth, Department of Economics, Universitat Pompeu Fabra, Barcelona.

In 1998, South Korea was in trouble. As the Asian financial crisis unfolded, its real GDP declined by five percent. At the same time, the won depreciated rapidly, and dollar-denominated GDP fell an astonishing 41 percent. Many South Korean firms that had borrowed in dollars before the peg was abandoned were now effectively bankrupt, the cost of servicing their debts almost doubled as a result of devaluation. Governments also tend to get into similar trouble. As the nation’s balance sheet collapses under the mounting burden of debt, the slump gets ever deeper. The situation in South Korea was not unusual — Indonesia saw a decline by 60 percent in dollar-denominated GDP, and Suriname holds the record in recent history for extreme movements, with a decline of 94 percent (in 1995).

There is little doubt that currency mismatches are an important contributing factor to instability in the third world. Countries often find it difficult to borrow abroad in their own currency. This exposes them to severe balance-sheet problems in case of devaluation. The debt burden can go from reasonable to crushing almost overnight if the devaluation is large enough, leaving the government and indebted firms bankrupt. As a result, sudden meltdowns — such as the Asian financial crisis — can turn flourishing countries into basket cases overnight. It is not quite clear if the crisis problem has grown more severe over the past hundred years, but financial crises occur with frightening frequency. They also pack a punch. They cost approximately nine percent of GDP, and the probability of any one country being hit in a given year is about eight percent. This suggests that financial crises — many of them involving foreign-currency denominated debt — cost emerging countries about one percent of average annual GDP growth.

If dollar-denominated debt is so dangerous, why don’t emerging countries issue in their own currency? Of the $5.8 trillion in debt floated on international markets in 1999-2001, fully $5.6 trillion were denominated in dollars, euros, yen, Swiss francs, and pounds. There are two schools of thought why this might be the case. Emerging markets may not be able to borrow in their own currency because their monetary institutions are poor, and fears of investors linger. This is what happened to Germany in the interwar period. After the hyperinflation, it could not float loans denominated in Reichsmarks. Only repayment in hard currencies like the dollar would then convince investors to part with their cash.

The alternative interpretation argues that the cards are somehow stacked against emerging markets — even with sound institutions, international investors discriminate against bonds denominated in the currency of third world borrowers to the point that they can’t be issued at all. This is what “original sin” is all about. Without ever having reached for forbidden fruits themselves, third world governments have been evicted from the financial Garden of Eden — borrowing in one’s own currency. In other words, the structure of the international financial system is to blame for the excessive volatility and wrenching crises that hit the third world every so often.

Barry Eichengreen and Ricardo Hausmann, who introduced the concept of “original sin,” have assembled an all-star line-up to investigate how far this story can be pushed. Economic historians, theorists, and specialists in contemporary macro/international economics are part of the team. In their introduction, Eichengreen and Hausmann show just how volatile exchange rates in emerging markets are — dollar-denominated GDP growth is twice as unstable as that of real GDP. This implies that the ability to repay debt is largely determined by exchange rate movements. As a result, the ability of governments to pursue counter-cyclical policies is severely constrained — fiscal expansion, for example, may be pointless if a declining exchange rate pushes debt servicing costs (in domestic currency) up and many firms to the wall.

Cespedes, Chang and Velasco present an elegant model that captures the consequences of original sin. This is surprisingly hard — the declining exchange rate should offset (through expenditure switching etc.) some of the negative consequences that come from the balance-sheet effect. With sufficient financial frictions, the key features of “original sin” crises can be replicated. At the same time, their model suggests that the total level of debt (domestic-currency and foreign-denominated), openness and the elasticity of output with respect to the exchange rate all matter in addition. In other words, countries with reasonable debt levels, a high degree of integration into the world economy, specializing in price-sensitive products will be able to reduce the effects of original sin.

Important evidence on the determinants of original sin comes from the nineteenth century. Marc Flandreau and Nathan Sussman show that countries with stable institutions and a high degree of fiscal rectitude (such as the Scandinavian countries) issued debt in sterling, while unstable countries with underdeveloped institutions such as Russia and Austria-Hungary succeeded in floating debt denominated in their own currency. They argue convincingly that the key factor for the ability to issue in their own currencies must have been the liquidity of the foreign exchange markets — countries whose currencies were quoted around the globe found enough takers of their bonds, too. This is powerful reinforcement of the transactions-cost interpretation of the “original sin.”

Michael Bordo, Chris Meissner and Angela Redish examine issuance by British dominions and the U.S. These countries all issued long-term debt in their own currency domestically, and they did not experience financial crises caused by balance sheet effects. The U.S. issued its foreign debt in dollars, but used a foreign exchange clause to reassure foreign bond holders. Issuance by the dominions in their own currency only started during WWI. Bordo, Meissner and Redish conclude that original sin “didn’t really matter.” While their title suggests that the U.S. and the dominions overcame original sin, their evidence seems to suggest that these countries never suffered much from it in the first place.

Olivier Jeanne examines why countries fail to borrow in their own currency. His paper is less supportive of original sin as an unfair mistake in the workings of the international financial system. Instead, he shows how debt denomination can be rationalized by lack of monetary credibility. His empirical work offers some support for this — the domestic issuance in countries like Brazil is largely in dollars, by both the government and the private sector. Redesigning the “international financial architecture” cannot resolve this issue directly.

Eichengreen, Hausmann and Panizza work hard to show that the standard explanations for original sin — weak domestic institutions, lack of credibility of the monetary authorities, etc. — do not hold water. They also highlight the interesting fact that in a number of exotic currencies such as the South African Rand and Czech Kronor, there is an active bond market. In all of these, much of the issuance is not by domestic institutions but by foreigners. For example, the Inter-American Development Bank has issued debt in Greek drachmas, New Zealand dollars, and the like. The authors argue that issuance by foreigners avoids the bundling of risks that comes from sovereign borrowers — when a government issues in its own currency, the risks of devaluation and default will be highly correlated. If this is the real lesson to be learnt from these cases, then the role of international financial architecture may be smaller than the editors think. They emphasize that diminishing returns to diversification — adding one more currency to a portfolio — plus transactions costs stop the developing world from issuing. Yet active bond market issuance in Czech Kronors, Singapore dollars and Taiwanese dollars by foreign entities suggests that the diversification benefits exist, or that the hedging needs of domestic entities make it possible to swap the currencies back into dollars at good rates. Since foreigners can clearly live with the currency risk, getting the default risk down to acceptable levels (and reducing the likely correlation between the two) by reforming institutions etc. should produce benefits that may be larger than the authors allow.

The authors demonstrate that indicators of institutional quality are not good predictors of “original sin” — coefficients are never robust and rarely significant. Yet this can only tell us so much. Measuring institutions is no small matter, with recent research demonstrating that most variables used so far exhibit deeply troubling short-run instability[ ]. At this stage, this reviewer remains agnostic about the extent to which the non-result for institutional variables demonstrates that the international financial system is at fault. Problems of measuring institutions remain formidable, and the authors do not demonstrate which features of the international capital market are at fault. Instead, they arrive at the conclusion by process of elimination of plausible alternatives. None of this detracts from the quality of the analysis presented in this book. It does much to further our understanding of an important feature of international capital markets, and it raises crucial policy issues. Some fifteen years ago, Robert Lucas asked why capital wasn’t flowing to the third world in huge quantities, given the capital scarcity and abundant labor supply. Today, capital flows are still a long way from equalizing returns, but their total volume is impressive compared to 1990. For international capital mobility to fulfill its promise, the “original sin” problem needs to be solved. Not content with highlighting the problem and analyzing its origins, Eichengreen and Hausmann present a detailed proposal, based on issuance by international financial institutions. Not everyone will agree that their suggestion is the best way forward, but no serious discussion about financial globalization’s discontents can avoid the issues raised in this book.

Note:

1. E. Glaeser, R. La Porta, F. Lopez-de-Silanes and A. Shleifer (2004) “Do Institutions Cause Growth?” Journal of Economic Growth, 9: 271-303.

Hans-Joachim Voth is ICREA Research Professor at the Economics Department, UPF, Barcelona, and a Research Fellow in the International Macro Program at the CEPR (London). He is currently working on the history of equity markets and the evolution of financial institutions in eighteenth century England. Recent publications include “Riding the South Sea bubble” [with Peter Temin], American Economic Review 2004, “Credit Rationing and Crowding Out during the Industrial Revolution: Evidence from Hoare’s Bank, 1702-1862” [with Peter Temin], Explorations in Economic History 2005, and “With a Bang, Not a Whimper: Pricking Germany’s “Stockmarket Bubble” in 1927 and the Slide into Depression,” Journal of Economic History 2003.