The Original Sin: An Analysis

In spite of the hard work of the international economic gurus, the problem of emerging market
catastrophes is not going away. When some bad news or a round of political turmoil afflicts a
country, investors get rid of their assets and the currency nose-dives. If this were the complete
effect, according to classical economics, it would lead to competitive and economical exports and
the crisis would solve itself. However, since a huge chunk of the emerging-market debt is
denominated in foreign currency, this leads to the ballooning of interest payments. In turn, fears
of difficulties in payment of the loans give rise to a vicious circle.
The heart of this phenomenon is that developing countries cannot borrow in the international
markets in their own currency. Hence, external debt is mainly denominated in foreign currency.
For example, during 1999-2001, they accounted for 8% of the debt but less than 1% of the
currency denomination.
Many would declare this is so since the plans and institutions of these countries are short of
trustworthiness. However, this experience is not particular to developing nations with poor track
records of economic governance. It has an effect on almost all countries except those issuing the
five main currencies. It affects countries with low inflation, stable finances and an unswerving rule
of law. As it is unclear what the countries have done to bring this trouble upon themselves,
economists refer to it as the "original sin".
What explains the concentration of the world's debt in a few currencies? For nations to be
successful in borrowing abroad in their local currency, the foreign investor must take a long
position in that currency. But it is difficult to imagine the retail investor managing a portfolio that
has many exotic currencies. Each extra currency improves the prospects for diversification but it
also increases costs and risks. Hence, the best and optimum portfolio will have a fixed number of
currencies.
Countries, therefore, face an uphill task when trying to add their currencies to the international
basket. Those who make it will make it more difficult for competitors as investors will have even
less appetite for other currencies of developing countries. Hence, the problem of the original sin is
not simply a problem of poor national policies. It is a problem with the international financial
framework and requires a global solution.
One promising solution can be a new unit - the EM index - based on a broad basket of emerging
market and developing country currencies. This unit would signify rights on a more diversified
economy and thus would be more stable, as shocks such as modifications in export prices, which
are positive for some economies, will be negative for others. Every currency in the set making up
the index would be weighted according to the country's inflation rate to shield investors from the
borrower's inducement to debase the index. Historically, such an index has been quite stable,
thus making it appealing to investors.
The World Bank, the International Monetary Fund and the other international financial institutions
(IFIs) should commence disbursing debt in the EM index. Their AAA ranking allows them to
access institutional investors and should create sufficient liquidity to make the bonds easily
tradable.
The IFIs will find it straightforward to get rid of the currency mismatch caused by issuing the EMindexed bonds. They can simply rework the dollar loans they have made to the countries in the
index into local currency CPI-indexed loans. They will, in this manner, eliminate the currency
disparity generated through their own lending, and become a way out for instead of a cause of
original sin.

Other high-quality issuers will then be able to expand the market further. The governments that
issue the five main currencies are the likely contenders to issue additional high-grade EMindexed debt. They are low-risk, AAA-rated borrowers too. Also, they have an interest in
eradicating the global volatility created by the original sin.
Of course, the developed countries will not want to expose themselves to a currency variance.
They will want to barter their currency exposure with the emerging markets. Precisely by doing
so, they will allow the developing countries 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 orthodox formula of macro-economic caution and institution building will not do away with the
original sin any time soon but encouraging the EM index market could do it.

Reference: - Original Sin: The Pain, the Mystery and the Road to Redemption by Barry
Eichengreen and Ricardo Hausmann.
Aayamtathaghat Banerjee