Original Sin Redux: a model-based evaluation

Discussion by Valentina Bruno

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2024 AEA session on Global Financial Cycles and Emerging Market Spillovers

Original Sin

• Eichengreen and Hausmann (1999): EME dependence on foreign currency (USD) borrowing

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• Overcoming Original Sin: Share of local currency denominated debt has increased

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• Carsten and Shin (2019) Original Sin Redux: Currency risk has shifted from borrowers to investors

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Good or Bad?

Good or Bad?

• An unfortunate news: Sovereign debt is associated with slower growth and more volatility (Aguiar, 2023, The Costs and Consequences of Sovereign Borrowing, Mundell-Fleming Lecture)

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• How about Local versus Foreign debt?

Good or Bad? Monetary policy tightening

RED= Local currency BLUE= Foreign Currency

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GDP, Investments and Exports drop less under LC debt

• Moving from FC to LC borrowing improves resilience to global financial spillovers, but it does not completely insulate from them

Good or Bad? – Effect coming from ex rate

• Larger depreciation of exchange rates in the case of LC

RED= Local currency BLUE= Foreign Currency

Bertaut, Bruno, and Shin, 2023 BIS WP

What can be done?

• Develop domestic investor base.

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This prescription is tantamount to asking EMEs to become wealthier so that institutional investors have larger asset portfolios

(Shin, University College London Centre for Finance, 2021 Annual Lecture)

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What can be done?

• Have a stable foreign investor base: pension fund and insurance sectors less procyclical than mutual fund sector, especially in the case of dollar denominated bonds
• Paradoxically, USD denominated bonds may be better than LC in presence of a stickier investor base
• Pension Fund and Insurance invest little in LC due to clientele effect

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• Understand the source of vulnerability:
• Currency and duration risk transferred from borrower to lender, but risk does not disappear

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Source: Bertaut, Bruno, and Shin (2023)

What can be done?

• Fiscal capacity as foreign investors are moving away from LC bonds

Holdings (USD billion) of government bonds in LC (BBS, 2023)

What can be done?

There are no definite answers

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• Original Sin -> borrowers’ currency risk

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• Original Sin Redux -> transfers currency and duration risk to investors
• Risk can circle back to the borrower

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• Fiscal capacity may be the answer to overcoming both Original Sin and Original Sin Redux

References

• Hyun S. Shin, 2021, Overcoming “original sin” to secure policy space https://www.bis.org/speeches/sp211111.pdf
• Carol Bertaut, Valentina Bruno, Hyun S. Shin, 2023, Original Sin Redux: Role of Duration Risk https://www.bis.org/publ/work1109.pdf
• Mark Aguiar, 2023, The Costs and Consequences of Sovereign Borrowing, Mundell-Fleming Lecture
• Mert Onen, Hyun S. Shin, and Goetz von Peter (2023). Overcoming original sin: insights from a new dataset. BIS Working Papers 1075.

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