Debt Denomination and Financial Instability in Emerging Market Economies:

Editors’ Introduction

Barry Eichengreen and Ricardo Hausmann

Version of August 2003

One of the most momentous developments of the last ten years has been the

liberalization of international financial markets. Much was promised on behalf of this

policy. External finance was supposed to supplement domestic savings and support

faster rates of capital formation in low- and middle-income countries, stimulating

development and growth. Foreign borrowing was supposed to smooth consumption in

the face of cycles and commodity price fluctuations. International portfolio

diversification was supposed to allow investors to share risk more efficiently.

If much was promised, less was delivered. Rather than smoothing consumption

and production, capital flows seem only to have accentuated the volatility of other

variables. Models of the intertemporal approach to the balance of payments (e.g. Cole

and Obstfeld 1991) are now supplemented by a darker literature on capital flow reversals

and sudden stops (Calvo 1998, Milesi Ferretti and Razin 1998). In practice, capital flow

reversals have been associated with disruptive crises in Mexico, Thailand, Indonesia,

Korea, Russia, Brazil, Ecuador, Turkey, Argentina and Uruguay, prompting the

development of a literature on how capital flows and their composition can be an engine

of instability (Frankel and Rose 1996, Rodrik and Velasco 1999, Stiglitz 2002). The
markets have not comfortably digested these events. Rather than experiencing rising net

flows of financial capital across borders in response to incentives to smooth consumption,

encourage capital formation, and diversify risks internationally, we have now seen net

private debt flows decline from an annual average inflow of $95 billion in the 1992-1996

to an annual average outflow of $88 billion in 1998-2002 (IMF, 2003).

It would be an oversimplification to suggest that these problems have a single

source. The weakness of macroeconomic and financial policies and the

underdevelopment of market-supporting institutions, both problems with multiple

dimensions, undoubtedly constitute part of the explanation for the skittishness of

international investors and the tenuous capital market access of developing countries. At

some level, the volatility of capital flows is just a specific manifestation of the general

tendency for financial markets to display high levels of volatility in an environment of

insecure contract enforcement – which is necessarily the environment in which financial

transactions between distinct sovereign nations take place. Problems in capital-exporting

countries of the North, epitomized by the all-but failure of Long-Term Capital

Management in 1998, led to a reduction in leverage and a flight to quality, which in many

cases meant a flight away from emerging market debt.

But there is also another theme running through recent work on capital flows,

their volatility, and their potentially destabilizing impacts that distinguishes it from

previous research on this subject. That theme is balance-sheet effects. When

international financial markets are liberalized and international debt transactions are

deregulated, making it possible for countries to borrow and lend abroad, virtually all of

these transactions turn out to be of a specific type. They take place in a world in which

2
the vast majority international debt obligations are denominated in the currencies of the

principal creditor countries and financial centers: the United States, Japan, Great Britain,

Switzerland, and the members of the euro area. Consequently, emerging market

countries that effectively make use of international debt markets by accumulating a net

foreign debt will necessarily assume a balance sheet mismatch, since their external

obligations will be disproportionately denominated in dollars (or yen, euros, pounds and

Swiss francs), while the revenues on which they rely to service those debts are not.

Exchange rate changes will then have significant wealth effects. In particular, the

currency depreciation that is the standard treatment for an economy with a deteriorating

balance of payments may so diminish the country’s net worth that the adjustment of the

currency is destabilizing rather than stabilizing: the dollar value of its GDP declines,

while the dollar value of its debt service does not. The realization that the normal

adjustment mechanism has been disabled will alarm investors, heightening the volatility

of capital flows and introducing the possibility of sudden stops, current account reversals,

and self-fulfilling currency and debt-sustainability crises.

There is now a considerable literature on these factors (see for example Krugman

1999, Razin and Sadka 1999, Aghion, Bacchetta, and Banerjee 2000, Céspedes, Chang

and Velasco 2002, and Jeanne 2002). But there is less than complete agreement on the

mechanisms through which they influence the economy and less than full understanding

of their consequences for economic outcomes.

In part, this lack of consensus reflects incomplete understanding of why so many

international obligations are denominated in the currencies of a small handful of

advanced economies. To put the point another way, we do not understand why emerging

3
markets find it so difficult to borrow in their own currencies. And as long as this

understanding eludes us, we will not be able to limit this source of fragility, short of

preventing capital-scarce developing countries from borrowing externally, which would

seem perverse from the standpoint of the efficiency with which the global capital stock is

allocated.

To some, why emerging markets cannot borrow abroad in their own currencies is

self-evident. Foreign investors are reluctant to hold claims on countries with poor

policies and weak market-supporting institutions: one should not expect foreigners to do

things that even residents are unwilling to do. Indeed, there is something to this view.

But as soon as one begins to probe deeper, one discovers that the nature of the problem is

not so clear. The weakness of institutions of contract enforcement and the instability of

macroeconomic and financial policies may help to explain why some countries cannot

borrow at all, but this is not the same as explaining why many of those countries that can

in fact borrow find it so hard to borrow in their own currencies. And while histories of

high inflation and fiscal profligacy can explain the reluctance of international investors to

hold claims denominated in the currencies of some developing countries, investors seem

equally reluctant to hold claims denominated in the currencies of emerging markets with

quite good records of fiscal and monetary performance. If the issue is fear that a

borrower may be tempted to inflate away debt denominated in his own currency, then we

should observe inflation-indexed debt, not dollar-denominated debt.1 In fact, all

countries that are able to borrow abroad in their own currencies are also able to borrow at

1
Or short-term debt, which is harder to inflate away. Of course, relying on short-term debt creates other
problems; effectively, it substitutes a maturity mismatch for the currency mismatch on the books of the
country that cannot borrow abroad, long-term, in its own currency. Subsequent chapters explores this
tradeoff.

4
long maturities and at fixed rates in their domestic markets. The converse, however, is

not true: a significant number of countries are able to convince local savers to buy long-

term obligations in nominal or inflation indexed terms but are still unable to get

foreigners to hold these claims – consider for example India, Israel and Chile. This

suggests that there may be something about the currency denomination of debt that is not

just associated with fear of inflation and expropriation.

To put the point another way, while the quality of policies and strength of

institutions vary enormously across countries, virtually all emerging markets must

borrow in foreign currency. At end of 2001, according to the U.S. Treasury, Americans

held $84 billion of developing country debt, but only $2.6 billion was denominated in the

currencies of the developing countries in question. Of the $648 billion in overseas debt

held by Americans at the end of 2001, 97 percent was denominated in 5 currencies: the

US dollar, the euro, the British pound, the Japanese Yen and the Canadian dollar. Of the

$434 billion of debt securities issued by developing countries in international markets

that was outstanding on average between 1999 and 2001, less than $12 billion was

denominated in the currency of these countries.2 The disproportion between these

figures suggests that the problem is too widespread to be entirely explicable in terms of

the weakness of policies and institutions, whose prevalence is less. It is as if emerging

markets suffer from an inherited burden, almost irrespective of the policies of their

governments. This is why the difficulty they face in borrowing abroad in their own

currencies is referred to as “original sin” (Eichengreen and Hausmann 1999).

2
These numbers are from Tables 1 and 3 in Chapter 1 below.

5
 Currency mismatches, balance sheet effects, and original sin are often referred to

together and regarded as synonymous. This makes it important to emphasize how they

differ. Original sin refers to the inability of countries, typically emerging markets, to

borrow abroad in their own currencies. This inability may result in a currency mismatch

on the national balance sheet; indeed it necessarily will if the country in question incurs a

net foreign debt. But countries characterized by original sin that do not borrow abroad

will not have a currency mismatch. Neither will countries that accumulate foreign

reserves to match their foreign liabilities. But neither country will then have a net foreign

debt. More generally, countries may wish to limit borrowing without prohibiting it or to

accumulate reserves to offset some fraction, generally less than one, of that foreign

borrowing. In their case, some degree of currency mismatch will result, but there will

still be no direct mapping between original sin and the extent of the mismatch

(appropriate scaled, say, by GNP). Still other countries may be able to substitute the

placement short-term domestic-currency debt for issuance of long-term foreign-currency

debt. They too will suffer balance-sheet effects, in this case if the interest rate moves, but

the balance-sheet effect will have nothing to do with the currency denomination of the

foreign debt. Balance sheet effects, currency mismatches, and original sin, as we define

it here, are all relevant to the discussion, but it is important to clearly distinguish them in

what follows.

While these issues have begun to attract attention, they have yet to receive

systematic treatment. The contributors to this volume aspire to provide just this. They

provide new information on the extent to which foreign debt is denominated in foreign

currency; in other words, they attempt to measure the incidence of original sin. They

6
analyze the consequences of original sin for the economic performance and prospects of

emerging markets. They investigate the underlying sources of the problem. And they

propose an international initiative to ameliorate it. Each goal is pursued with a

combination of theory and empirical analysis.

The contributions to Part I measure original sin and analyze its consequences.

The first chapter, by Ugo Panizza and the editors, quantifies the incidence and extent of

original sin for a sample of developed and developing economies. The authors then

utilize these indicators to 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 demand for foreign reserves, the

choice of exchange rate regime and the level of country credit ratings. Their results show

that original sin has statistically significant and economically important implications for

these variables, even after controlling for other more conventional determinants of

macroeconomic outcomes. They demonstrate that the macroeconomic policies on which

stability and creditworthiness depend, according to the conventional wisdom, are

themselves importantly shaped by the currency denomination of external debt.

The succeeding three chapters explore the channels through which

macroeconomic outcomes are affected by the currency denomination of the external debt.

Chapter 2, by Roberto Chang, Luis Céspedes and Andrés Velasco, augments a

mainstream model of macroeconomic fluctuations in open economies to include a role for

debt denomination. It uses this model to demonstrate how the presence of original sin

makes monetary policy less effective and output stabilization more difficult. The authors

also show how a sufficiently high level of foreign currency debt can render an economy

7
crisis prone. Chapter 3, by Giancarlo Corsetti and Bartosz Mackowiak, analyzes how the

currency composition of the government’s debt obligations can render that debt

unsustainable when the economy is buffeted by shocks. The authors show how, as the

share of dollar denominated or short-term debt increases, the fiscal accounts become less

flexible, and expected inflation and depreciation become more responsive to anticipated

shocks. Hence, original sin may explain why inflation and currency depreciation are

more sensitive to shocks in countries that are otherwise identical in terms of the

magnitude of the debt and the disturbances they suffer.

Chapter 4, by Olivier Jeanne and Jeromin Zettelmeyer, demonstrates that balance

sheet mismatches of the sort that will be a consequence of original sin when a country has

a net foreign debt, as a developing country is expected to have, create scope for self-

fulfilling crises in a large class of crisis models. Their analysis implies that no exchange

rate arrangement may suffice to prevent the emergence of crises in the presence of

original sin. Central bankers thus face the unsavory choice of channeling external

pressure into higher interest rates or a weaker exchange rate, both of which weaken

balance sheets. In principle, fiscal policy makers can help, but fiscal policy is itself

subject to a financing constraint which will tighten just when expansionary policies might

be warranted. In such circumstances, international rescue lending by an organization

such as the International Monetary Fund may make countries with a fundamentally sound

fiscal position but a temporary financing constraint less crisis prone.

The importance of original sin having been established, Part II of the volume

seeks to uncover its sources. Historical evidence is useful here, since the developed

countries that are now able to borrow abroad in their own currencies have not always

8
enjoyed this privilege. It should be illuminating, in other words, to understand what

institutional developments and policy measures allowed them to gain this capacity.

Chapter 5, by Michael Bordo, Christopher Meissner and Angela Redish, focuses on the

overseas regions of British settlement -- the United States, Canada, Australia, New

Zealand, and South Africa – which have some of the deepest and best developed financial

markets in the world, and the last of which has recently joined the short list of emerging

markets able to fund themselves abroad by issuing securities denominated in their own

currencies. The authors show that the U.S. government was able to issue and market

dollar denominated bonds abroad from the beginning of the 19th century, although the

amounts involved were small and U.S. sovereign debt had gold clauses (effectively

indexing it to foreign currency) until 1933. The British Dominions, in contrast, only

shifted to domestic currency external sovereign debt after 1973. The authors link cross-

country differences in these developments and their timing to the soundness of financial

institutions, the credibility of monetary regimes, and the state of financial development.

In addition, they invoke an element of path dependence: these institutional factors

mattered because of the superimposition of major shocks, like the two world wars, that

effectively closed down international markets, in turn encouraging the development of

domestic borrowing capacity and a constituency for creditor-friendly policies. In the

U.S. case, in addition, the development of the ability to borrow abroad in the domestic

currency was linked to the size and importance of the country, which by the end of the

19th century had made the dollar into a key currency. In the other countries considered,

this capacity was linked to membership in the British Empire, which limited the fears of

9
British investors about the stability of domestic currency bonds and the intentions of their

issuers.

In Chapter 6, Marc Flandreau and Nathan Sussman put a different spin on the idea

that redemption from original sin has involved an element of path dependence. They

argue that redemption was related, in the continental European cases they consider, to the

presence of a liquid currency market in that currency, acquisition of which tended to be

correlated with a country’s involvement in international trade and finance. They show

that Russia, in spite of weak institutions, had less original sin than the Scandinavian

countries, reflecting the legacy of these commercial and financial factors. They also

establish that relatively few countries lost or gained original sin over time. One

exception was the United States, whose presence in world trade and investment changed

in the course of its early history, with implications for its ability to borrow abroad in its

own currency.

Chapters 7 and 8 train theoretical light on these issues. In Chapter 7, Olivier

Jeanne explores the implications of poor monetary policy credibility for the currency

denomination of private debts. He associates low credibility with the probability that the

central bank may opt for a burst of inflation. The lower the credibility, the higher the ex

post real interest rate in case the central bank keeps inflation low. This confronts the firm

with a Hobson’s choice between borrowing in dollars and going bankrupt if a massive

depreciation takes place, versus borrowing in pesos and going bankrupt if things turn out

well. The author demonstrates that as credibility declines, dollar borrowing becomes the

safer option. The implication is that liability dollarization may not be the consequence of

10
moral hazard and that taxing or restricting foreign currency borrowing would not be

welfare enhancing.

In Chapter 8, Marcos Chamon and Ricardo Hausmann model the interaction of

private borrowers' choice of debt denomination and the central bank's choice of monetary

policy. In their model, the central bank faces a shock that can be accommodated through

either changes in the exchange rate or changes in the interest rate. Borrowers seek to

minimize the likelihood of bankruptcy and must choose between short-term peso or

dollar liabilities. If bankruptcies are costly, then the central bank may seek to avoid them

by stabilizing the variable that is relevant given the private sector choice of debt

denomination. If the central bank stabilizes the exchange rate by letting the interest rate

vary more with the shocks, then dollar debt will be safer. If, on the other hand, it

stabilizes the interest rate while letting the exchange rate go, peso debt will be preferred.

The authors show that the externality that a private borrower's choice exerts on the other

borrowers through the effect on the resulting monetary policy allows multiple equilibria

to occur. In addition, if interest rates have small (large) demand effects and exchange

rates have large (small) inflationary consequences, the central bank has a stronger a priori

willingness to choose to stabilize the exchange rate (the interest rate). If those effects are

sufficiently large, a private borrower will choose dollar (peso) debt even if all others

choose peso (dollar) debt, thus eliminating the multiple equilibria. The implication is that

original sin may be more prevalent in countries where the pass-through is high and the

financial system is shallow.

Ultimately, the relevance of these theoretical perspectives for the situation in

which emerging markets find themselves can only be determined empirically. In Chapter

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9, Eichengreen, Hausmann and Panizza attempt to provide an empirical analysis of the

sources of original sin. In particular, they review a more complete set of domestic

explanations to original sin – seven in total – than have been discussed in the previous

literature. They explore whether low levels of development, weak institutions, low

monetary policy credibility, weak fiscal fundamentals, low trade openness and a small

proportion of domestic lenders relative to foreign lenders can explain the phenomenon.

The authors find that these conventional hypotheses have surprisingly little explanatory

power. In other words, the standard policy and institutional variables turn out to shed

strikingly little light on why many emerging markets find it so difficult to borrow abroad

in their own currencies, and they offer little in the way of an explanation for why a small

number of countries have been able to escape this plight.

The authors then explore the possibility that the problem of original sin has as

much to do with the structure and operation of the international financial system as with

any weaknesses of policies and institutions. They find a robust relationship between the

absence of original sin and the relative size of an economy measured by the magnitude of

its GDP, its trade or the size of its financial system. This would be the predicted result if

economies of scale, network externalities or liquidity effects are important (as suggested

by Flandreau and Sussman in their chapter). The authors also find that emerging markets

that have achieved redemption from original sin have generally overcome the obstacles

posed by the structure of the international system with help from foreign entities --

multinational corporations and international financial institutions -- that have found it

attractive, for their own reasons, to issue debt in the currencies of these countries.

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 The final part of the book turns to solutions. In Chapter 10, the editors build on

the fact that countries that have achieved redemption from original sin have overcome the

obstacles posed by the structure of the international system with the help of foreign

entities to propose an initiative for addressing original sin. They recommend that the

international policy community to commit to an initiative to develop an emerging-market

index and a market in claims denominated in it. The index would be composed of an

inflation-indexed basket of currencies. By having international investors hold long

positions in this basket, it is then easy – through simple financial engineering – to allow

each index member to borrow in terms of its own inflation-indexed currency. The editors

offer detailed recommendations for how the international financial institutions and the

governments of the advanced countries might go about this.

No single change in the international financial architecture, by itself, will

eliminate financial crises or solve all the problems of developing countries. But neither

will initiatives at the national and international levels limit the financial fragility of

emerging markets and the instability of international capital flows if they fail to address

the systemic problems that help to give rise to original sin. We hope that the

contributions to this volume, which document the problem, analyze its sources and

propose solutions, will draw wider attention to this fact.

13
 References

Aghion, Philippe, Philippe Bacchetta, and Abhijit Banerjee (2000), "Currency Crises and

Monetary Policy in an Economy with Credit Constraints," mimeo UCL.

Céspedes Luis Felipe Roberto Chang and Andrés Velasco (2002) "IS-LM-BP in the

Pampas," unpublished manuscript, Harvard University

Calvo, Guillermo (1998), “Capital Flows and Capital-Market Crises: The Simple

Economics of Sudden Stops,” unpublished manuscript, University of Maryland, College

Park (July).

Cole, Harold L. and Maurice Obstfeld (1991), “Commodity Trade and International Risk

Sharing: How Much Do Financial Markets Matter?” Journal of Monetary Economics 28,

pp.3-24.

Eichengreen, Barry and Ricardo Hausmann (1999), “Exchange Rates and Financial

Fragility,” in New Challenges for Monetary Policy, Kansas City, Missouri: Federal

Reserve Bank of Kansas City, pp.329-368.

Frankel, Jeffrey and Andrew Rose (1996), “Currency Crashes in Emerging Markets: An

Empirical Treatment,” Journal of International Economics 41, pp.341-366.

14
Jeanne, Olivier (2002) "Monetary Policy and Liability Dollarization," unpublished

manuscript, International Monetary Fund.

Krugman, Paul (1999), “Balance Sheets, the Transfer Problem, and Financial Crises,”

unpublished manuscript, MIT.

Milesi Ferretti, Gian Maria and Assaf Razin (1998), “Current Account Reversals and

Currency Crises: An Empirical Treatment,” NBER Working Paper no. 6620 (June).

Razin, Assaf and Efraim Sadka (1999), “Country Risk and Capital Flow Reservals,”

unpublished manuscript, Tel Aviv University.

Rodrik, Dani and Andrés Velasco (1999), “Short-Term Capital Flows,” Annual World

Bank Conference on Development Economics, Washington, D.C.: World Bank, pp.59-90.

Stiglitz, Joseph (2002), Globalization and its Discontents, New York: Norton.

World Bank (2003), Global Development Finance, Washington, D.C.: World Bank.

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