The evolution of original sin

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One of the great (almost) untold positive global development stories of the past decade is the amelioration of “original sin”.

The economists Barry Eichengreen, Ugo Panizza and Ricardo Hausmann were the first to call the dangerous dependency on foreign-currency borrowing the “original sin” of emerging markets. Since a series of debt debacles in the 1980s and 1990s, this original sin has ameliorated if not eliminated by the nurturing of vibrant local bond markets in most major developing countries.

We can see the positive impact today. In the past, the kind of interest rate hiking increases we have recently seen from the Federal Reserve would have broken swaths of emerging markets. This time, the pain is mostly in a smattering of smaller countries, rather than, say, Mexico or South Korea — countries that are of systemic importance.

However, a few years ago the Bank for International Settlement’s big beasts — general manager Agustín Carstens and chief economist Hyun Song Shin — argue that it has only evolved rather than been eliminated.

Specifically, they pointed out that the currency mismatch risk had just been shifted from borrowers to lenders — international investors buying local-currency bonds in places like Ghana were now exposed to the danger of nasty currency swoons.

Shin, Carol Bertaut of the Federal Reserve and Valentina Bruno have revisited this thesis to also incorporate duration risk into the analysis. This is timely, given how a lot of emerging markets also took advantage of the great post-2008 reach for yield to lengthen the average maturities of their bond markets.

Unsurprisingly, duration risk — the greater sensitivity of longer-term bonds to interest rates — turns out to be “key channel for the transmission of market conditions”. Alphaville’s emphasis below:

This is the most notable finding of our paper. Emerging market sovereigns have joined the trend of borrowing at longer maturities taking advantage of yield chasing behavior set off during the low-for-long period of monetary policy. While issuing longer maturity bonds mitigates rollover risk for the borrowers, longer maturity bonds come with greater duration risk for the investor where by a given yield change is associated with a larger percentage price change. Fluctuations in market values due to duration risk, rather than traditional vulnerabilities due to currency mismatch or maturity mismatch, have taken center stage in market condition dynamics.

Duration risk is particularly potent due to its interaction with currency risk. Our working hypothesis is that investors do not pre-hedge the currency risk when entering the local currency bond market, and instead aim to time the market and benefit from a stronger local currency even as the yields fall. Global portfolio investors evaluate their returns in dollar terms (or in other hard currency terms), so that exchange rate fluctuations that accompany yield changes tend to amplify duration risk. The combination of duration and currency risks generates a “wind chill” effect that weighs on investors and elicits portfolio adjustments that further amplify shocks.

Second, mutual funds are not typical of other investor sectors and they tend to exhibit much greater sensitivity to shifts in financial conditions. Mutual funds substantially reduce their holdings of local currency bonds following dollar appreciation, and do so much more than other sectors especially for longer maturities bonds.

The greater sensitivity of mutual fund outflows to shifts in financial conditions is consistent with the arguments in Chen, Goldstein and Jiang (2010), who relate the flow dynamics to strategic complementaries and financial fragilities, and in Falato, Goldstein, and Hotacsu (2021) who highlight the role of open-ended bond funds in the propagation of financial stress during the COVID-19 crisis. To the extent that investor reactions to duration risk amplify market disruptions, lengthening maturities may increase the sensitivity of the domestic yield curve to global financial conditions.

In contrast to the mutual fund sector, other investors exhibit a lower sensitivity to changes in financial conditions, and tend to maintain a steady portfolio. Indeed, for some sectors, there is evidence that they take the other side of the exposures shed by the mutual fund sector. For this reason, aggregate portfolio flows are less procyclical than studies of mutual funds alone would suggest. Nevertheless, the large heft of the mutual fund sector leaves a strong imprint on aggregate flows.

Third, we identify longer-term shifts in the investor base in EME capital markets. Even as emerging markets have largely overcome Original Sin by issuing sovereign bonds in local currency, the portfolio flows due to foreign investors have ebbed. Notably, we find that domestic investors absorb most of the sell-off of local currency bonds by foreign investors. This may eventually bring back risk from the lender to the borrower, coupled with the fact that about half of new sovereign debt issuance has ended up on domestic bank balance sheets between 2020 and 2021 (Obstfeld, 2021). In this respect, fiscal space for the government has become more dependent on domestic investors to absorb greater issuance.

. . . Taken as a whole, our findings run counter to the presumption that emerging market woes are due mainly to EM governments borrowing in foreign currency because local currency flows display sensitivity to shifts in global financial conditions. The novelty of our findings also run counter to the presumption that longer maturity debt alleviates vulnerabilities. Given that risk has to do with market risk due to the higher duration, it is instead very natural that the rise of new vulnerabilities is associated with longer maturity debt. Our findings highlight the importance of market risk as compared to the traditional vulnerabilities like currency mismatch or maturity mismatch, a theme that is at the core of the current debate after the September 2022 turmoil in UK gilts and the Silicon Valley Bank blow-up in March2023.

OK OK so this is a bit long, but their argument is that simply dumping the FX and duration risks on to investors doesn’t insulate a country from the ebb and flow of the global cycle, nor shield it from financial crises. “Borrowing in domestic currency turns out not to be a panacea,” they conclude.

Fair enough. But no one has ever said that it was a panacea?

All the paper’s conclusions look basically valid and important to bear in mind, but clearly, borrowing more in your own currency and minimising rollover risks with longer maturities is better than the opposite. This is about risk amelioration, not elimination.

And if you look at emerging markets today (and just don’t focus too much on the smaller but very sad cases) the overall picture is miles better than it was a generation ago, and certainly better than what you’d previously expect after the most aggressive Fed tightening pace in four decades.

And that is in large part thanks to the receding of the original sin Hausmann, Panizza and Eichengreen identified back in the 1990s.