Mistery of Original Sin

8/8/2019 Mistery of Original Sin

1/61

1

The Mystery of Original Sin

Ricardo Hausmann, and Ugo Panizza*

July 16, 2002

(This Version March, 2003)

Comments Welcome

1. Introduction

Most countries do not borrow abroad in their own currency and cannot borrow in local currency

at long maturities and fixed rates even at home, a fact that Eichengreen and Hausmann (1999)

refer to as Original Sin. This state of affairs creates financial fragility as countries that suffer

from this problem are likely to be characterized by either currency mismatches (because of the

*Kennedy School of Government, Harvard University, and Research Department Inter-American

Development Bank. Email: [email protected] and [email protected]. We are

grateful to the Bank for International Settlements and in particular Rainer Widera and Denis Ptre

for data on currency denomination of foreign debt, J.P. Morgan and in particular Martin Anidjar

for data on local markets and Pipat Luengnaruemitchai for data on capital controls. We are also

grateful to Barry Eichengreen and Ernesto Stein for very useful collaboration in this project,

Kevin Cowan, Marc Flandreau, Eduardo Levy-Yeyati, Nathan Sussman, Jean Tirole, Philip

Turner and participants at seminars at Harvard University, the Inter-American Development Bank

and the Latin American and Caribbean Economic Association for useful comments.


2/61

2

currency composition of the debt) or maturity mismatches (because of the short-term nature of the

domestic currency debt). Eichengreen, Hausmann and Panizza (2002) show that countries with

original sin exhibit greater output and capital flow volatility, lower credit rating, and limited

ability to manage an independent monetary policy.

This paper describes the incidence of the problem and makes an attempt at uncovering its cause.

In particular, the paper tackles the following questions: Which countries borrow internationally in

their own currency and which do not? Which countries borrow domestically in local currency at

fixed rates and long maturities? What economic fundamentals are associated with this behavior?

These questions have become important for the debate on financial crises. On the one hand,

exchange rate mismatches associated with liability dollarization can expose balance sheets to

serious risks associated with a positive feedback between large real exchange rate depreciations

and perceptions of insolvency. On the other hand, reliance on short-term borrowing can expose

balance sheets to roll-over risks, especially when the debt is in foreign currency so that the

cewntral bank cannot assure its liquidity. Both problems can become self-fulfilling as they

generate the potential for multiple equilibria1.

The empirical evidence on the ability to borrow abroad in local currency (call it the international

dimension of original sin) presented in Hausmann, Panizza and Stein (1999) and in Bordo and

1The Latin American debt crisis of the early 1980s, the Mexican 1994 crisis and the East Asian

crisis of 1997 had clearly a bit of both, as the foreign debt was largely short term and in foreign

currency. In Ecuador (1999), Argentina (2001) and Uruguay (2002) the short term foreign

currency obligations included the domestic banking system.


3/61

3

Flandreau (2001) suggest that the set of countries that actually borrow internationally in their own

currency is quite a select group with many usual suspects (e.g., G-3), a few surprises (e.g.

Australia, New Zealand, Poland and South Africa) and some interesting no shows (e.g. Austria,

Chile, Finland, Ireland, Sweden). The domestic dimension of original sin, i.e. the ability to

borrow at long maturities and fixed-rates in local currency in the home market - has received less

systematic attention. In this paper we update the data on international original sin and develop

indicators for the domestic component.

After describing the phenomenon, we consider a wide range of hypotheses aimed at explaining

the determinants of original sin. In particular, we discuss and test seven theories.

The first theory focuses on the importance of institutions for financial markets in particular and

more broadly for the level of development. The second theory focuses on monetary credibility and

suggests that when monetary credibility is low, interest rates in domestic currency will be high.

Firms will be faced with the choice of borrowing in dollars and subjecting themselves to currency

risk or opting for the risky strategy of borrowing in very expensive terms domestically (Jeanne,

2002).

The third theory is closesly related to the second and focuses onfiscal solvency. It suggests that

countries with weak public finances will have an incentive to debase their currencies.

Anticipations of this may cause the market to disappear. Dollarizing the debt or making it very

short term eliminates the incentive to do so (Lucas and Stokey 1983, Calvo and Guidotti 1990)


4/61

4

The fourth theory focuses on credit market imperfections or poor contract enforcement.

According to this theory, the domestic-currency debt market may disappear when there is a

positive correlation between default and depreciation risk, since this creates a moral hazard

problem on the borrower who can expropriate his local currency lenders by taking on more

foreign currency debt (Chamon, 2002, Aghion, Bachetta and Banerjee, 2002).

The fifth theory focuses on the choice of exchange rate regime. Countries with a fixed exchange

rate should experience much of their nominal volatility in the domestic-currency interest rate,

while countries that float will see larger exchange rate volatility. Borrowers would then prefer

domestic currency debt in floating rate countries and fixed rate debt in flexible exchange rate

countries.

The sixth theory focuses onpolitical economy arguments. According to this theory, when

foreigners are the main holders of domestic currency debt, governments will have an incentive to

debase their currencies. In this sense, international markets in domestic currency can only arise in

presence of a domestic constituency of local currency debt holders.

The seventh theory focuses on international causes, emphasizing the role of economies of scale in

liquidity which limit the incentives for diversification. An implication of this theory is that

country size matters. Currencies from larger country have an advantage in the international

market because the larger size of their economies and currency issues makes them liquid and

stable and hence attractive as a component of the world portfolio.


5/61

5

The paper is organized as follows. Section 2 describes and quantifies the international and

domestic dimension of original sin. Section 3 describes and tests the theories outlined above.

Section 4 concludes.

2. What do we know about Original Sin?

The definition of original sin focuses on the inability to borrow long-term in domestic currency

(even within the domestic market) and the inability to borrow internationally (even short-term) in

domestic currency. The purpose of this section is to describe these two dimensions of Original Sin

for a sample of developed and developing countries. Rather than building an aggregate index of

Original Sin, we will start by discussing its foreign and domestic components separately and then

analyze the relationship between the two components.2

2.1 The International Component of Original Sin

To measure whether a given country is able to borrow internationally in its own currency, we use

data on international debt securities from the Bank of International Settlements (BIS). The BIS

data set contains information on debt instruments (both long and short-term) disaggregated by

nationality of issuer and by currency. We use this data set to build proxies of currency

mismatches in the countrys balance sheets that we deem to be associated with the inability of

2Claessens et al. (2003) build a measure of total original sin (domestic plus international) for

government bonds. Their index assumes that all bonds issued domestically are in domestic

currency.


6/61

6

countries to borrow internationally in their own currency. In building our Original Sin indexes,

we follow Hausmann, Stein and Panizza (2001) but extend their sample from 30 up to 91

countries and update it to the end of 2001. Before describing the indexes of original sin and

illustrating their cross-country variation, we want to reiterate the point that the world portfolio of

cross-border bonds is composed of very few currencies.

The size of the problem3

Table 1 presents data on the currency composition of bonded debt issued cross-border between

1993 in 2001. (Cross-border means that Table 1 excludes local issues.) We split the sample into

two periods, demarcated by the introduction of the euro. The figures are the average stock of debt

outstanding during in each sub-period. The information is organized by country groups and

currencies of denomination. The first country group, financial centers, is composed of the US, the

UK, Japan, and Switzerland; the second is composed of the Euroland countries; the third contains

the remaining developed countries; and the fourth is made up of the developing countries; we also

report data on bond issues by the international financial institutions. Column 1 presents the

amount of average total stock of debt outstanding issued by residents of these country groups.

Column 2 shows the corresponding percentage composition by country group. Columns 3 and 4

do the same for debt issued by residents in their own currency, while columns 5 and 6 look at the

total debt issued by currency, independent of the residence of the issuer. Column 7 is the

proportion of the debt that the residents of each country group issued in their own currency (the

3The discussion in this sub-section is from Eichengreen, Hausmann and Panizza (2002)


7/61

7

ratio of column 3 to column 1), while column 8 is the proportion of total debt issued in a currency

relative to the debt issued by residents of those countries (the ratio of column 5 to column 1).

Notice that while the major financial centers issued only 34 percent of the total debt outstanding

in 1993-1998, debt denominated in their currencies amounted to 68 percent of that total. In

contrast, while other developed countries ex-Euroland issued fully 14 percent of total world debt,

less than 5 percent of debt issued in the world was denominated in their own currencies.

Interestingly, in the period 1999-2001 following the introduction of the euro the share of debt

denominated in the currencies of other developed countries declined to 1.6 percent. Developing

countries accounted for 10 percent of the debt but less than one per cent of the currency

denomination in the 1993-1998 period. This, in a nutshell, is the problem of original sin.

Column 8 reveals that in 1999-2001 the ratio of debt in the currencies of the major financial

centers to debt issued by their residents was more than 150 per cent.4

This ratio drops to 91.3

percent for the Euroland countries, to 18.8 percent in the other developed countries (down from

32.9 percent in the previous period), and to 10.9 percent for the developing nations. Notice that

after the introduction of the euro, Euroland countries narrow their gap with the major financial

centers while other developed countries converge towards the ratios exhibited by developing

nations.5

4This, in a sense, is what qualifies them as financial centers.

5Whenever we observe a drop in Original Sin (this happens for Czech Republic, New Zealand,

Poland, Singapore, Slovak Republic, South Africa, and Taiwan) this always happens because of


8/61

8

All this points to the fact that currency mismatches are a global phenomenon. They are not

limited to a small number of problem countries. In a sense, the phenomenon seems to be

associated with the fact that the vast majority of the worlds cross-border financial claims are

denominated in a small set of currencies.

Measuring Original Sin

We measure original sin with two different indicators. Our first indicator of international Original

Sin (OSIN1)6

is equal to one minus the ratio between the stock of international securities issued

by a country in its own currency and the total stock of international securities issued by the

country. Formally:

an increase in the numerator (ie debt issued in domestic currency) and not a drop in the

denominator (ie total international debt).

6This indicator is one minus what Hausmann et al. (2001) call ABILITY1. It should be noted that

we are assuming that countries cannot borrow abroad in their own currency and that our index of

original sin captures this inability. However, some countries may not be borrowing abroad

because they do not want to. This implies that what we actually observe is the minimum of the

ability to borrow in domestic currency and the optimal share of domestic currency debt (i.e., the

share of domestic currency debt we would observe if countries were not constrained). Therefore,

we are implicitly assuming that the constraint is always binding. As this assumption may be less

likely to hold for developed countries, we always check whether the results explain the within

country groups variation in original sin.


9/61

9

i

iiOSIN i

countrybyissuedSecurities

currencyincountrybyissuedSecurities11 =

Therefore, a country that issues all its securities in own currency would get a zero and a country

that issues al its securities in foreign currency would get a one. This index has two problems.

First, it only covers securities and not other debts. Second, it does not take account of

opportunities for hedging currency exposures through swaps. To capture the scope for hedging

currency exposures via swaps, we use the ratio between international securities issued in a given

currency (regardless of the nationality of the issuer) and the amount of international securities

issued by the corresponding country. Formally:

i

iINDEXBi


currencyinSecurities1=

INDEXB accounts for the fact that debt issued by other countries in ones currency creates an

opportunity for countries to hedge currency exposures via the swap market. Unlike OSIN1,

INDEXB can take negative values indicating that the total amount of securities in currency i is

larger than the total amount of securities issued by residents of country i. We expect to find

negative values for currencies such as the US dollar or the Swiss franc that are commonly used as

international store of value. We are interested inINDEXB because if non-residents borrow in a

given countrys currency, residents may be able to swap their foreign currency obligations with

the domestic currency instruments issued by non-residents and hence fully hedge their currency

risk. However, these countries cannot hedge more than the debt they have. Hence, they derive


10/61

10

scant additional benefits from having excess opportunities to hedge. We therefore substitute zeros

for all negative numbers, producing our second index of original sin:7

= 0,


currencyinSecurities1max3

i

iOSIN

i

OSIN3 is our favorite measure of Original Sin because, by capturing the possibility of hedging

exchange rate risk, it provides an aggregate measure of currency mismatch.

In previous work, we also used an index that covered both bonded debt and bank loans (OSIN2 in

Eichengreen, Hausmann and Panizza, 2002). While this index had the advantage of wider

coverage, it was a less precise measure of original sin because the currency breakdown of bank

loans is only available for the five major currencies. Hence OSIN2 understated original sin by

assuming that all debt that is not in the 5 major currencies is denominated in local currency (we

addressed this issue by using OSIN3 as a lower bound for OSIN2). In our empirical analysis, we

address the issue of coverage by weighing all our regressions by the ratio between total

international bonds issued by country i, and total debt (bonds plus loans) issued by country i.

Table 2 presents the average of OSIN1 and OSIN3 for the different country groupings and

different parts of the developing world. As before, we observe the lowest numbers for the major

financial centers, followed by Euroland countries (which exhibit a major reduction in original sin

after the introduction of the euro). Other developed countries exhibit higher values, while the

highest values are for the developing world. The lowest values in the developing world are in

7We call our second index OSIN3 to keep notation consistent with our previous work

(Eichengreen, Hausmann, and Panizza, 2002)


11/61

11

Eastern Europe, while the highest are in Latin America. The table also shows that, depending on

the region, international bonds represent between one fifth and one half of international debt.

If we move beyond international averages, it is possible to find large differences within groups.

Table 3 lists countries that are not financial centers or part of the Euro area and have measures of

OSIN3 below 0.8 in 1999-2001. The list includes several future Eastern European accession

countries and overseas regions of European settlement (Canada, Australia, New Zealand and

South Africa). Notice further that both fixed-rate Hong Kong and floating-rate Singapore and

Taiwan appear on this list, raising questions about whether any particular exchange rate regime

poses a barrier to redemption.

By comparing OSIN1 with OSIN3, it is possible to identify who are the issuers in a given

currency. IfOSIN1 is equal to one and OSIN3 smaller than 1, foreign issuers dominate the

international market for a given currency. It is interesting to note that, while in the case of OECD

countries, national issuers cover a large share of the international issue in domestic currency

(reflected by low levels ofOSIN1), there is no developing country with a value ofOSIN1 that is

below 0.95. South Africa and Poland are the countries with the lowest value of OSIN1 (0.95 and

0.96, respectively). This suggests that developing countries escape from Original Sin only thanks

to debt issued by foreign investors (captured by OSIN3).

But who are the issuers in the Euromarket for emerging market currencies? J.P. Morgan (2002)

points out that the market for paper denominated in Czech and Slovak korunas, Polish zloty,

Hungarian forints, and South African rands is dominated by multinationals with high credit rating


12/61

12

that issue local currency bonds and then swap the proceeds and future repayments into hard

currency. The bonds used on the other side of the swap are government bonds denominated in US

dollar or Euro issued by the respective countries.

Corporations and governments adopt this strategy rather than directly issuing bonds in the

currency they want to be exposed to because it allows to separate country risk from currency risk

and leads to lower financing costs for both the local currency and hard currency issuers. Formally,

the interest paid by a domestic currency bond issued by an emerging market government ( ) has

three components: a safe interest rate (that for simplicity we set at zero), a currency risk (), and

a sovereign risk ( ). So: += . The volatility of the return is:

),cov(2)var()var()var( ++=

As long as currency risk and country risk are positively correlated (as they are likely to be)

combining the two risks increases the volatility of returns. Having local currency bonds issued by

highly rated foreigner and having foreign currency bonds issued by the resident separates the two

risks and, by reducing the volatility of returns, lowers financing costs.

2.2 The Domestic Component of Original Sin

This section focuses on the domestic component of Original Sin defined as the inability to borrow

domestically long-term at fixed rates in local currency. Our main source of information is J.P.


13/61

13

Morgans (2002, 2000, 1998) Guide to Local Markets that reports detailed information on

domestically traded public debt for 24 emerging market countries. J.P. Morgan also provides

information on the presence of domestic private debt instruments and shows that in most

countries (the exceptions being Singapore, South Korea, Taiwan, and Thailand) this is a

negligible component of traded debt.

J.P. Morgan reports data on total outstanding domestic government bonds (column 1 of Table 4)

and the main characteristics (total amount, maturity, currency, and coupon) of the various

government bonds present in each market. Columns 2-6 of Table 4 classify the bonds listed by

J.P. Morgan according to their maturity, currency, and coupon (fixed rate and indexed rate). In

particular, it divides outstanding government bonds into 5 categories: (i) long-term domestic

currency fixed rate (DLTF); (ii) short-term domestic currency fixed rate (DSTF); (iii) long-term

(or short-term) domestic currency debt indexed to interest rate (DLTII); (iv) long-term domestic

currency debt indexed to prices (DLTIP); and (v) foreign currency debt (FC).8

Using the data of Table 2, we compute the following three indicators of domestic Original Sin.

8It should be noted that columns 2-6 do not always add up to column 1. In some cases, the bonds

described by J.P. Morgan do not cover total outstanding government bonds. In other instances,

they include central bank bonds that are not considered as government bonds (this is the case of

Chile, for which columns 2-6 add to USD 15 billion versus USD 5 billion of total outstanding

government bonds). However, in most cases columns 2-6 add up to a value that ranges between

95 and 103 percent of total outstanding government bonds.


14/61

14

DLTIPDLTIIDSTFDLTFFC

FCDSIN

++++

=1

DLTIPDLTIIDSTFDLTFFCDLTIIDSTFFCDSIN

++++

++=2

DLTIPDLTIIDSTFDLTFFC

DLTIPDLTIIDSTFFCDSIN

++++

+++=3

The first definition focuses on foreign currency debt while the second definition focuses on both

foreign currency debt and domestic currency short-term debt (or long-term but index to the

interest rate) and therefore focuses on both currency and maturity mismatches. The third

definition is even more inclusive and also considers long-term debt indexed to prices, leaving out

only the long-term fixed-rate domestic currency debt.

It should be clear that while the definition of Original Sin focuses on total debt, we only have

information on traded debt (and mostly public debt). Hence, our indexes do not include

information on bank loans and, if a country has a market for long-term fixed rate bank loans but

no market for long-term fixed rate debt instruments, our indexes may overestimate Original Sin.

If, on the contrary, a country has a market for long-term fixed rate debt instruments but no market

for long-term fixed rate bank loans, our indexes will provide a lower bound for Original Sin.

Table 5 ranks the countries in our sample according to the three measures of domestic Original

Sin. It shows that very few countries have a large stock of domestic public debt in foreign

currency. In fact, only Argentina has more than 50 percent of its domestic public debt in foreign


15/61

15

currency and only Brazil and Turkey have more than 25 percent of their domestic public debt in

foreign currency. This might be due to the fact that domestic investors interested in buying

foreign currency debt issued by their own government may find it more appealing to operate in

the international market and enjoy the protection of New York or British law. If such a preference

exists, sovereign spreads will be lower in the international market and hence emerging market

issuers will have fewer incentives to issue foreign currency debt domestically.

By contrast, if the foreign debt is private and in foreign currency, original sin implies that there

will be limited international ability to hedge currency exposures, as foreigners are in principle

unwilling to take a long position in local currency (otherwise we would observe domestic

currency lending, as a dollar loan plus a hedge is the same as a domestic currency loan). Under

these circumstances, the government may decide to transfer the currency risk onto its own balance

sheet by issuing dollar denominated debt that the private sector can hold in order to hedge its

currency exposure or that banks can hold to offer currency hedges to the corporate sector.

When we focus on the second or third definitions of Original Sin, we find that more than half of

the countries in our sample have indexes that are above 50 percent. Only 5 out of the 22 countries

of Table 4 have more than three-quarters of their public debt in long-term fixed rate domestic

currency bonds.

2.3 Comparing International and Domestic Original Sin


16/61

16

In our rather limited sample of 21 countries for which we have both domestic and international

measures of original sin, there is a positive but not very strong correlation between our two

measures of international original sin (OSIN1 and OSIN3) and our three measures of domestic

original sin (DSIN1, DSIN2 and DSIN3) (Table 6).

There are several reasons why domestic and international original sin might be related. Most

simply, if a country is unable to convince its own citizens to lend in local currency, because of

poor monetary or fiscal credibility, one should not expect foreigners to do so either. Hence, in this

story, the same logic explains original sin in both spheres. By contrast, another rationale can

explain how international original sin can cause the domestic version. If a country has a net

foreign debt and it is in foreign currency, real exchange rate movements will have aggregate

wealth effects. The central bank may thus show a preference for less exchange rate volatility9

and

will hence be willing to tolerate more interest rate volatility. This will limit the development of

the domestic long-term market.

Figure 1 presents the scatter plot between OSIN3 and both DSIN2. We include lines for values of

our indexes that are equal to 0.75 in order to create 4 relevant quadrants. Note that the upper left

hand quadrant is empty: no country with high domestic original sin has low international original

sin. This suggests the first logic above: convincing your residents to lend in local currency at long

maturities seems to be a necessary condition to convince foreigners to do the same. Note also that

the lower right hand corner is not empty: this suggests that a low domestic measure of original sin

9This point is made empirically in Hausmann, Panizza and Stein (2001) and in Eichengreen,

Hausmann and Panizza (2002).


17/61

17

is not a sufficient condition for being able to borrow abroad in local currency. The countries in

this group include India, Israel, Hungary, Philippines, Chile, Slovakia and Thailand. It is

interesting to check what factors make these countries different from the ones in the lower left

hand corner: i.e. countries with low measures of original sin in both fronts (Poland, Czech

Republic, South Africa, Hong Kong, Taiwan and Singapore). Possible candidates include: a

history of inflation, a history of capital controls, a large net external or fiscal debt.

We tested whether the difference between these two groups of countries can be accounted for by

differences in the level of capital controls.

10

We find that for the twelve countries involved, the

average of capital control index is significantly higher in the countries with international original

sin (p-value of 0.084, 10 degrees of freedom). By contrast, the inflationary history and the size of

the public debt are not statistically different in the two groups of countries (p-values 0.23 and

0.50, respectively). With respect to measure of total external debt, we find some evidence that

countries without original sin have a smaller level of external debt. Here we use data from the

World Bank Global Development Finance, which has the effect of limiting our sample to 9

countries and 7 degrees of freedom. The p-value of the difference is 0.053.

10The index covers the 1990-1995 period and was kindly provided by Pipat Luengnaruemitchai.

Luengnaruemitchai built the index of capital controls for the 1990-1995 period by computing the

principal component of 4 sub-indexes measuring capital account restrictions, current account

restrictions, presence of multiple exchange rates, and surrender requirements. The data are from

the IMFs annual report on exchange rate arrangements.


18/61

18

Finally, 8 out of 20 countries in our sample have both domestic and international Original Sin;

this latter group includes Argentina, Brazil, Egypt, Indonesia, Malaysia, Mexico, Turkey and

Venezuela11

.

The analysis in this section should be taken with extreme care. We are working with a very small

sample of countries for which we have both measures of domestic and international original sin.

We suggest tentatively that the development of long-term domestic markets may be a necessary

but not sufficient condition for the elimination of international original sin. We find some role for

the size of the external debt and the presence of exchange controls in explaining international

original sin among countries with low domestic original sin. We will show later that capital

controls are negatively related to domestic original sin: i.e. they promote long-term domestic debt

markets. However, this implies that such a reduction in domestic original sin is unlikely to be

accompanied by a reduction in international original sin. We will return to them below.

3. What are the Causes of Original Sin?

The purpose of this section is to use the data described in the previous section to test the various

theories of Original Sin described in the introduction. Because of data availability our main focus

will be on the international component of original sin, but we will also make an attempt to use

information on the domestic component.

11Chile also belongs in this group for the case of DSIN3 but not in DSIN2 as most of the

domestic debt is indexed to the price level.


19/61

19

3.1 International Original Sin

Our data on international original sin consist of an unbalanced panel of up to 91 countries over the

1993-2001 period. In testing the various theories of original sin, we need to decide whether to

only use the cross-country variation of the data or also exploit its time series variation. While one

would be tempted to say that the answer to this question is obvious (use all the possible

information and hence exploit the panel nature of the dataset!), before jumping to conclusions one

should recognized that original sin has very limited time variation. This can be illustrated by

regressing OSIN1 and OSIN3 on a set of country dummies and looking at the fraction of the

variance (i.e, the R2 of the regressions) explained by these time invariants controls. We find that,

over the 1993-2001 period, time invariant factors explain 84 percent of the variance of OSIN3

and 96 percent of the variance of OSIN1, indicating that the key explanation does not lie in the

time-varying factors which, in the best of cases, can only explain 16 percent of the phenomenon.

One may claim that this limited time variation is due to the fact that our panel is fairly short (8

years) and countries take decades to build credibility or other variables that can explain original

sin. Interestingly, we find that original sin is surprisingly persistent even if we look at 150-year

period. Flandreau and Sussman (2002) collected information on the structure of the international

bond market in the mid 19th

century. Their data can be used to build a three-way classification of

original sin, based on whether countries placed bonds in local currency, indexed their debt to

gold, or did some of both. Table 7 shows the mean value of OSIN3 in the 1993-1998 period for

each of the three groups distinguished by Flandreau and Sussman. OSIN3 is highest today in the


20/61

20

same countries that had gold clauses in their debt in the 19th

century (average 0.84), lowest for

countries that issued domestic debt (average 0.33), and intermediate in countries that issued both

gold-indexed and domestic-currency debt (average 0.50).

Given the persistence of the phenomenon, our focus will be on cross-country variation. However,

we will also exploit the panel nature of our data to address some reverse causality issues. Our

main dependent and explanatory variables are measured as 1993-1998 averages of the key

underlying variables (the only exception is inflation that is averaged over a longer period).12

Although we have data, we do not use information for the 1999-2001 period because the

introduction of the Euro changes the meaning of the measure of original sin for Euroland

countries.13

As OSIN1 and OSIN3 are bounded between zero and one, we use a double-censored

Tobit model. We also weigh all our regression with the ratio between bonded international debt

and total international debt in order to capture the idea that measures of original sin based on bond

data are more representative of the true measure, the larger the bonded debt is in total debt.14

12This is to capture the idea that it takes a long time to build monetary credibility. Average

original sin is not computed by averaging the indexes but instead by using the average of the

denominator and numerator of the index. Because of data availability capital controls are

measured as 1990-1995 average.

13In the panel analysis, we use data for the whole period but drop Euroland observation for the

1999-2001 period.

14Switzerland and Luxembourg are two outliers and their inclusion in the sample would drive

most of the results. Therefore all the regressions discussed in this section do not include these two

countries.


21/61

21

We start by discussing each theory in detail and then test the theory by using a battery of simple

regressions. Next, we run a set of regressions where all the explanations are jointly tested. Finally,

we use over-time variation to try to sort out reverse causality issues.

The level of development

A first class of explanations for the ability of countries to borrow abroad in own currency focuses

on non-well specified weaknesses in policies and institutions. As the quality of policies and

institutions is highly correlated with the level of development, we start by looking at the

correlation between Original Sin and GDP per capita (measured in logs). The results are reported

in Table 8. The first column looks at the simple correlation between the GDP per capita and

OSIN3 and finds a strong correlation between the two variables. The coefficient is also

economically significant indicating that the difference in GDP per capita between developing and

developed countries is associated with a drop in original sin of 0.8 points. However, this result is

not robust to the inclusion of other regressors. In particular, if we control for country groupings

(financial centers, Euroland, other developed countries) the estimated coefficient and the t-

statistic drop by about half, although the coefficent remains statistically significant at the 5

percent level. In equation 3 we control also for the size of the economy and here the coefficient on

the level of development declines again by half and becomes insignificant. Columns 4 and 5 focus

on OSIN1 and show that the correlation between this variable and GDP per capita is only

significant when we do not control for country grouping.15

15Since OSIN1 has very limited variance, especially in the sample of developing countries, from

now on, we will concentrate our analysis on OSIN3.


22/61

22

It is striking that once we control for country size, GDP per capita, a measure that should fully

capture the quality of country policies and institutions, is not significantly associated with original

sin. The fact that original sin does not have a robust relationship with the level of development

suggests that country characteristics that are correlated with the level of development are also

unlikely to explain the variance in original sin.

The lack of correlation between institutions and original sin does not disappear if we look at

institutional forms that are closer to international financial issues, such as the presence of capital

controls. These controls are more prevalent in less developed financial markets. They are likely to

discourage international investors from holding instruments denominated in a given currency

since ceteris paribus foreigners will look unfavorably at a currency that cannot be easily

converted into hard currency. The last two columns of Table 8 test for the presence of a

correlation between the Luengnaruemitchai index of capital controls and original sin. We find that

while there is a strong simple correlation between capital controls and original sin, this

relationship does not survive the introduction of country-grouping dummies.16

Monetary Credibility

The second hypothesis postulates that original sin is a symptom of inadequate policy credibility.

This is important for both domestic and international original sin. On the domestic side, Jeanne

(2002) argues that when monetary credibility is low, interest rates in domestic currency will be

high and firms will be faced with the choice of borrowing in dollars and subjecting themselves to


23/61

23

currency risk or opting for the risky strategy of borrowing in very expensive terms domestically.

He shows that as monetary policy becomes less credible, borrowing in foreign currency becomes

less risky relative to local currency borrowing and that a prudent borrower subject to idiosyncratic

shocks will prefer to borrow in dollars and default in bad times than to borrow in pesos and

default in good times.

On the international side, if the monetary and fiscal authorities are inflation prone, foreign

investors will be averse to lending in a unit that the borrower can manipulate.17

They will lend

only in foreign currency, which is protected against inflation risk, or at short maturities, so that

interest rates can be adjusted quickly to any acceleration of inflation. This leads to clear policy

prescriptions. Redemption form original sin can be achieved by setting up appropriate institutions

(like an independent central bank) and developing a reputation for price stability. One problem

with models that emphasize the role of credibility is that Original Sin could be more simply

overcome by issuing inflation-indexed debt (Chamon, 2002).18

We nevertheless do not find that

these instruments, liquid in Chile, Israel and the United Kingdom, have much international role.

16It is also not robust to the inclusion of a size variable such as the log of GDP.

17This does not recognize that foreigners are not one party and therefore they do not internalizes

the increased incentive for the government to inflate when they lend in domestic currency (we

would like to thank Jean Tirole for pointing this out).

18Tirole (2002) argues that governments could still attempt to influence the real exchange rate.

However, the ability of the government to influence this relative price in a sustained manner is

questionable and the political case for doing it is less compelling.


24/61

24

We explore the cross-country correlation between original sin and monetary credibility in Table

9. As a proxy of monetary credibility, we use the average of log inflation for the 1980-1998

period (INF), we control for non linearities by introducing inflation squared (INF2) and also

experiment with average log inflation over the 1970-1998 period (INF70-98) and the highest level

(in logs) of inflation over the 1980-1998 period (MAX_INF).19

All the regressions of Table 11

yield a consistent result. Inflation is positively correlated with original sin when we do not control

for country grouping but the correlation disappears when we control for country groupings

indicating that inflation does not explain the within group difference in original sin20

.

Figure 2 plots the correlation between OSIN3 and average inflation. The figure suggests that low

inflation is a necessary but not sufficient condition for redemption from original sin. No country

with a history of high inflation has low original sin,21

but there are plenty of virtuous country that

do not borrow abroad in own currency. Thus, while inadequate anti-inflationary credibility may

help to explain the inability of a few chronic high-inflation sufferers to borrow abroad in their

own currency, it cannot explain the extremely widespread nature of the phenomenon.

Fiscal solvency

19 We use the 1980-1998 period to give inflation the maximum chance to explain original sin.

20The relationship between inflation and original sin also becomes statistically insignificant when

we control for size.

21This is not surprising. Studies of the determinants of deposit dollarization found a causal

relationship from inflation to deposit dollarization (quote Borensztein).


25/61

25

The third theory focuses on fiscal sustainability. Governments that have weak fiscal accounts will

have an incentive to debase the currency in order to erode the real value of their obligations

(Lucas and Stokey, 1983, Calvo and Guidotti, 1990). Corsetti and Mackowiak (2002) put this

argument in a dynamic context and find that there is a vicious circle in which, in the presence of

weak public finances, a large stock of foreign currency public debt poses serious constraints to

agents ability to borrow in domestic currency. The reasoning goes as follows: if fiscal solvency

problems are addressed through inflation, the larger the stock of public foreign currency debt, the

larger will be the inflation/devaluation necessary to restore fiscal equilibrium. This makes it less

attractive for others to lend in local currency. Therefore, as the economy approaches serious

solvency problems domestic currency debt disappears.

To explore the relationship between original sin and fiscal fundamentals we use the debt to GDP

ratio and debt to revenue ratio. The latter indicator is better suited at measuring fiscal

sustainability because public debt is serviced not out of GDP, but out of the fraction of GDP that

the government can get hold of. In emerging market countries, tax systems are more inefficient

and collect a smaller fraction of GDP. Hence, even with low debt to GDP ratios, their ability to

service the debt may be limited by low tax revenues. We use two different sources for our data.

Both data sets are from the International Monetary Fund. The first is from the publicly available

International Financial Statistics data set (DE_GDP1 and DE_RE1) and the second from the

dataset used to compute the aggregate statistics of the World Economic Outlook (DE_GDP and

DE_RE). The latter dataset (which we obtained on a confidentiality basis) has a more limited

coverage but a broader measure of the public sector and is hence likely to be more accurate.


26/61

26

Table 10 reports the results and indicates no significant correlation between fiscal variables and

original sin. In most cases, the variables even have the wrong sign indicating that original sin is

negatively correlated with high debt to GDP or high debt to revenue ratios.

Our finding of no correlation between original sin and fiscal is corroborated by the experience of

several developing and developed countries. In particular, large fiscal deficits and debt levels

never prevented Japan or Italy from borrowing abroad in their own currency. At the same time,

there are several emerging market countries with very solid fiscal fundamentals but are

nonetheless chronically unable to borrow abroad in their own currencies (Chile is a case in point

for Latin America, while Korea is a good example for Asia).

Credit market imperfection and poor contract enforcement

The fourth theory focuses on credit market imperfections and poor contract enforcement. The key

references here are Chamon (2002) and Aghion, Bacchetta and Banerjee (2001). They discuss a

class of models in which when a company defaults, its assets are distributed among the creditors

in proportion to their nominal claims on it. If depreciation and default risk are correlated, then

domestic currency lenders will likely see a double decline in the value of their claims when a

default occurs: they will receive a portion of the residual value of the company which will be

diminished by the concomitant depreciation. If all lending takes place simultaneously, domestic

currency lenders will charge for this effect. However, if lending takes place sequentially firms

will have an incentive to increase the proportion of foreign currency lending after borrowing in

local currency in order to transfer part of the residual value of the defaulted company from old


27/61

27

domestic-currency lenders to new foreign-currency investors. In anticipation of this, the domestic

currency market will disappear. In this setting, domestic currency lending would happen only if

courts could enforce complicated contracts that give more seniority to domestic currency creditors

that entered the market at an earlier stage.

We test this theory by looking at the correlation between original sin and an index of rule of law

compiled by Kaufman et al. (1999). We find that rule of law is significantly correlated with

original sin when we do not control for other variables but the relationship is not robust to the

inclusion of other variables such as country grouping dummies (columns 1 and 2 in Table 11)

22

.

We also experiment with the index of creditor rights assembled by La Porta et al., 1999 which is a

measures that is more directly related with credit market imperfections but is measured for fewer

countries and obtain similar results.

The exchange rate regime

The fifth class of explanations focuses on the choice the exchange rate regime. Countries with a

fixed exchange rate should experience much of their nominal volatility in the domestic-currency

interest rate, while countries that effectively float will see larger exchange rate volatility. Risk

averse borrowers and lenders would then prefer to use foreign currency debt denomination in

countries where the central bank is committed to exchange rate stability and local currency in

countries where the central bank favors interest rate stability (Chamon and Hausmann, 2002).

Burnside, Eichenbaum and Rebelo (2001) suggest that fixed exchange rate create moral hazard

22The inclusion of a measure of size such as log of GDP also reduces drastically the coefficient,

which remains significant only at the 10 percent level.


28/61

28

and lead to excessive foreign currency borrowing. Stabilizing the exchange rate, in their view,

creates moral hazard; it conveys the impression that the government is socializing exchange risk,

encouraging the private sector to accumulate unhedged exposures. In fact, many analysts have

argued that original sin (or liability dollarization) is caused mainly by fixed exchange rates.

Here, however, reverse causality is a serious issue. Hausmann Panizza and Stein (2001) and

Calvo and Reinhart (2002) show that emerging market countries tend to suffer from fear of

floating and that original sin seems to be a very good predictor of how much exchange rate

flexibility countries will actually tolerate. Levy-Yeyati and Sturzenegger (2002) also show that

liability dollarization is a good predictor of the de facto exchange rate regime. Chamon and

Hausmann (2002) solve this simultaneous problem and show that original sin may be the

consequence of more fundamental determinants of the central banks reaction function. Exchange

rate adjustments will be seen as less (more) appealing in countries with a high (low) pass-through

of exchange rate movements into prices, with contractionary (expansionary) effects of

depreciation and with a low (high) impact of interest rate movements on aggregate demand.

We look at the correlation between original sin and exchange rate regime by using the de facto

classification of Levy-Yeyati and Sturzenegger (2000). As the Levy-Yeyati and Sturzenegger

index (LYS) increases with exchange rate rigidity (one indicates floating rate and 3 fixed rates),

we expect a positive correlation between LYS and original sin. The last two columns of Table 11

show that the correlation has the expected sign but the coefficient is very small and is not

statistically significant.


29/61

29

Political economy

The sixth theory focuses on the government incentives to debase the currency. A domestic

constituency of local-currency debt holders prepared to penalize a government that debases the

currency will provide strong incentives to respect the value of the local currency. By contrast, if

foreigners are the main holders of public and private debts, then there is likely to be a larger

domestic political constituency in favor of weakening the value of their claims. Therefore, foreign

creditors will be reluctant to lend in local currency unless protected by a large constituency of

local savers. Tirole (2002) makes this point explicit by assuming that the government cannot

commit to protect the rights of foreigners whose welfare it does not value. Redemption can

therefore be achieved by developing domestic financial markets.23

According to Tiroles model, original sin depends on a host of institutional factors that are not

easily measurable. They include: the level of domestic savings, their location (home versus

abroad), the extent of control rights held by political authorities, and the interest of dominant

political forces. (Tirole, 2002, page 32) . We proxy the level of domestic savings with two

measures of the size of the financial sector: domestic credit to the private sector as a share of GDP

(DC_GDP) and quantity of money as a share of GDP (M2_GDP). We proxy for the location of

savings with a measure that tries to capture the size of the domestic financial sector relative to

total international debt that is obtained by computing the ratio between foreign liabilities

23According to Tiroles model, in presence of commitment problems, Original Sin arises from the

presence of government incentives to borrow in domestic currency. In this setting, Original Sin is

commitment device and hence a second best solution.


30/61

30

(measured as the sum of bank claims and securities from the two BIS databases described above)

and domestic credit (FOR_DOM).24

The theory predicts a negative correlation between each of

DC_GDP and M2_GDP and Original Sin and a positive correlation between FOR_DOM and

original sin.

Table 12 shows the results of the regressions.25

We include three equations for each independent

variable of interest. Equations 1, 4 and 7 are include only the variable of interest (i.e. DC_GDP,

M2_GDP and FOR_DOM). Equations 2, 5 and 8 control for country grouping dummies.

Equations 3, 6 and 9 control also for SIZE. We find that there is a strong bivariate correlation

between original sin and DC_GDP and M2_GDP. This relationship weakens with the inclusion of

country dummies and disappears once one includes SIZE. FOR_DOM always has the right sign,

but is seldom statistically significant.

Note that this weak result happens in spite of the fact that reverse causality i.e. original sin

causes weak financial systems should have biased the estimates upwards. We conclude that there

is scant evidence to suggest that financial development or the presence of a large domestic credit

market can significantly contribute to explain the cross-country variation in original sin.26

24Note that we are implicitly assuming that most domestic credit is in own currency.

25The regressions do not include the offshore centers because they tend to have very high values

of FOR_DOM.

26Political economy effects should be stronger in democracies. We tried to test this hypothesis by

interacting domestic credit over GDP with the ICRG index of democracy but found that the

interaction had the wrong sign (the effect of domestic credit over GDP decreases with democracy)

and was not statistically significant.


31/61

31

International factors

So far, we found scant support for our six theories of original sin. So, we are left without an

answer to what explains the concentration of the world portfolio in few currencies or the fact that

it is mainly large countries that seem to be able to issue foreign debt in their own currencies?

Hausmann and Rigobon (2003) suggest that, in presence of international transaction costs, the

benefits of diversification are larger for small countries. Under these circumstances, large

countries have limited incentives to hold currencies issued by small countries. This is no fault of

the small country, but a consequence of the existence of cross-border costs and asymmetries in

size and diversification.

An implication of this approach is that country size matters for original sin. Large countries have

an advantage in shedding original sin because the large size of their economies and currency issue

makes it attractive as a component of the world portfolio. In contrast, the currencies of small

countries add little diversification benefits relative to the additional transaction costs they imply.

While Hausmann and Rigobon (2003) focus on the benefits of diversification, Flandreau and

Sussman (2002) propose a different connection between trade (and indirectly country size) and

original sin. They first observe that European countries with a large presence in international trade

in the 19th

century were able to avoid original sin quite independently of the quality of their

institutions because there existed spot and futures currency markets in their currencies, arising out

of the demand by traders to hedge their exposures. The existence of these markets facilitates the

issuance of financial claims denominated in those currencies because investors can also use those


32/61

32

markets to hedge their exposures. Flandreau and Sussman show that there is some evidence of

this mechanism at work in 19th

century Europe. One can similarly see evidence of it in Mexico in

the 1990s, when following the negotiation of the NAFTA agreement there developed a deep and

liquid futures market in Mexican pesos on the Chicago Mercantile Exchange, in turn facilitating

the Mexican governments placement of peso-denominated debt securities.

We study the correlation between country size and original sin using four measures of size: log of

total GDP (LGDP), log of total trade (LTRADE), log of domestic credit (LCREDIT) and an index

built using the principal component of the first three (SIZE). We find that size is always strongly

negatively correlated with original sin. Large countries are less sinful (Table 13). We already

pointed out that in the case of GDP, the effect goes through total GDP and not GDP per capita

(Table 8). The same is true in the case of trade, it is total trade and not openness that matters

(openness is never significantly correlated with original sin).

SIZE can explain why large countries like the US and Japan do not suffer from original sin. But

what about Switzerland and, for that matter, the UK? Countries that either are or were major

commercial powers (e.g. the US and Japan today, Britain in the past) clearly have a leg up; the

developing countries are not major commercial powers, by definition. In addition, some countries

have been able to gain the status of financial centers as a quirk of history or geography (e.g.

Switzerland, a mountainous country at the center of Europe which was hard to take over and also

small enough to retain its neutrality, became a convenient destination for foreign deposits).

Network externalities giving rise to historical path dependence have worked to lock in their

currencies international status: once the Swiss franc was held in some international portfolios and


33/61

33

used in some international transactions, it became advantageous for additional investors and

traders to do likewise. This does not deny that additional countries cannot gain admission to this

exclusive club, but it suggests that they face an uphill battle.

Putting things together

The tests conducted so far have found only found a strong correlation between original sin and

country size and country grouping dummies. We now move on and jointly test the different

theories by running a battery of multivariate regressions. For each theory, we pick the variable

that either has the strongest correlation with original sin or the one that maximizes the sample.

Since fiscal variables are available for a relatively small set of countries and have been shown to

have no significant correlation with original sin, we exclude them from our baseline regression.

Table 14 shows the results. Column 1 runs the baseline regression without controlling for country

groups. Column 2 controls for country groups. Column 3 adds an additional dummy that takes

value 1 for offshore centers. Column 4 controls for the debt to GDP ratio. Column 5 runs a

regression without weights. Column 6 runs OLS instead of a Tobit model. Column 7 uses an

index of original sin that is not bounded at zero (INDEXB instead of OSIN3). All the regressions

yield a consistent message: the only variable that is robustly correlated with original sin is country

size. GDP per capita, inflation, and the index of exchange rate flexibility are statistically

significant in one out of seven regressions. All the other explanatory variables are never

statistically significant. Figure 3 plots original sin and country size (after controlling for country


34/61

34

groups) and shows that the negative correlation between these two variables is not driven by

outliers.

Reverse causality

The result that domestic factors are not correlated with original sin is clearly puzzling. The first

critique that a skeptical may level at our results (or lack of) is that our empirical specifications

does not control for reverse causality. We already discussed that this may be an issue for the

correlation between original sin and the choice of the exchange rate regime, but there are several

other variables that may be affected by original sin. In this sub-section, we discuss possible

channels of reverse causality and do our best to address the problems that they may cause.

While our estimates found no significant relationship between original sin and inflation, one may

argue that the estimated coefficient is attenuated by the endogeneity of inflation. The argument

goes as follows: in presence of large amount of dollar debt, the benefits from inflation are low and

hence, in presence of original sin we never observe inflation. Reverse causation of this kind

would be the reason for the low estimated coefficients. Clearly, this is not the only form of

reverse causality: original sin lowers the base of the inflation tax and hence, for the same shock,

would require higher inflation. However, this logic would cause an amplification bias. In previous

work (Eichengreen Hausmann and Panizza, 2002), we tried to address this issue by instrumenting

inflation with an index of central bank independence and could not find any statistically

significant relationship between original sin and inflation. We now try to address the reverse

causality issue by exploiting the time series variation of our sample (in interpreting the results one

should always remember that only 15 percent of the variance of original sin is due to its over-time


35/61


36/61

36

that a country will choose a fixed regime. As before, we start by looking at whether the choice of

the exchange rate predicts original sin and find that the lagged value of LYS is marginally

significant (column 7). The coefficient, however, is very small. It indicates that moving from a

fixed exchange rate (LYS=3) to a floating rate (LYS=1) is associated with a drop in original sin

of 0.07 points. We also make an attempt at instrumenting the choice of the exchange rate.

Openness has all the characteristics for being a good instrument. It is not directly correlated with

original sin and there is some evidence that is correlated with the choice of the exchange rate

regime (Levy-Yeyati and Sturzenegger, 2002). Column 8 shows the results of the instrumental

variable estimations. We now find that the coefficient attached to LYS switches sign (indicating

that a fixed exchange rate leads to less original sin) but remains insignificant. Column 9 shows

that original sin is a predictor of LYS.

Reverse causality could also affect the relationship between original sin and financial

development. In particular, if original sin causes greater volatility and economic instability, it

could also be the cause of a smaller financial system. We follow the same procedure we used

before and look at whether domestic credit over GDP is a predictor of original sin. Columns 10

and 11 show that there is no correlation between these two variables.

Summarizing, our panel estimations confirm the robust negative relationship between country

size (measured as total GDP) and original sin. They also confirm the general negative findings for

the other explanations of original sin. They do however provide some evidence for a relationship

that goes from inflation to original sin, but the coefficient is extremely small, implying that

inflation can only explain a very small fraction of the total variance of original sin.


37/61

37

3.2 Domestic original sin

We now check whether the various theories discussed above play a role in explaining domestic

original sin. We present results for both DSIN2 and DSIN3. We caution against over-interpreting

our results as they are based on a small sample of up to 21 countries. Tables 16a and 16b present

the basic results and Figures 4a and 4b show scatter plots for all the regressions of tables 16a and

16b. Column 1 finds that the relationship between SIZE and domestic original sin in its two

variants has the unexpected positive sign: larger countries seem to have more domestic original

sin. However, the results are not statistically significant27

. Column 2 finds a similar result for

LGDP_PC.

Column 3 finds a positive and significant relationship between inflation and domestic original sin.

This result is robust to the inclusion of other regressors such as the exchange rate regime and

capital controls (equations 8 and 9).

Column 4 finds that the correlation between RULEOFLAW and domestic original sin has the

right sign but is not statistically significant. Column 5 finds that DC_GDP has the right sign, is

27The non-negative relationship between SIZE and domestic original sin are quite robust. The

results are affected by the presence of two large countries Brazil and India which have similar

size but very different measures of original sin. Dropping them individually or simultaneously

does not change the result.


38/61

38

barely statistically significant for DSIN2 but not for DSIN3. Column 10 shows that this result is

further weakened if we control for AV_INF.

Column 6 shows that CAPCONTR has a negative correlation with DSIN2 and DSIN3 implying

that the presence of stronger capital controls is associated with less domestic original sin. This

unconventional result is not statistically significant. However, when controlling for AV_INF

(column 9), the results become statistically significant and large. The coefficient implies that

increasing capital controls from the 25th

percentile to the 75th

percentile among this group of

countries would lower DSIN2 and DSIN3 by about 0.25

28

.

Column 7 presents the results for the exchange rate regime LYS3. The effect on DSIN2 is

positive and significant indicating that fixed exchange regimes have measures of DSIN2 which

are about .5 larger than floating regimes. The result is not statistically significant for DSIN329

.

The result is robust to the inclusion of AV_INF, LGDP and LGDP_PC (not shown). However, the

results disappears if one controls for CAPCONTR. Studying this issue further we found that in

our sample CAPCONTR are strongly correlated with the exchange rate regime: floaters such as

Chile, India and Poland have high capital controls while fixers such as Argentina and Hong

28The effect of capital controls on DSIN is robust to the inclusion of LGDP and LGDP_PC as

long as AV_INF is in the regression. The interpretation is that countries with high inflation tend

to impose capital controls. Controlling for that, capital controls seem to lower DSIN.

29Note that the difference between DSIN2 and DSIN3 is the treatment of long-term debt indexed

to the price level. Countries such as Chile, which have a large stock of such debt have low DSIN2

but high DSIN3.


39/61

39

Kong have very open capital accounts30

. The interpretation is that floaters tend to impose capital

controls, but once you take account of the controls, floating does not help in explaining DSIN.

The scatter plots suggests that the results (or lack of results) of tables 16a and 16b are not driven

by outliers (possibly with the exception of domestic credit over GDP).

While it is hard to reach conclusions based on a sample of 22 countries, the results described

above seem to suggest that domestic policies such as the imposition of capital controls, the

maintenance of low inflation and arguably the imposition of floating exchange rates have an

impact on the domestic dimension of original sin but not for its international dimension. Monetary

credibility is key in overcoming domestic original sin but it is not sufficient to redeem countries

from international original sin.

4. Conclusions

What should be taken from the exercises described in this paper? The currency composition of

foreign debt and the structure of domestic debt exhibit very large cross-country variations. First,

internationally traded securities are denominated in very few currencies, mainly of the large

industrial countries and financial centers. Second, the few exceptions to this rule, such as Czech

Republic, Hong Kong, Poland, Singapore, South Africa and Taiwan are explained not by

residents issuing internationally in the countrys own currency (OSIN1), but of foreign entities

30The negative correlation between CAPCONTR and LYS3 is robust to dropping Hong Kong

and Argentina.


40/61

40

doing so (OSIN3-OSIN1). We argue that this may be a reflection of the presence of a positive

correlation between currency risk and credit risk for domestic issuers. Third, we find a relatively

low correlation between the ability to borrow internationally in domestic currency and the ability

to do so domestically at long maturities and fixed rates (DSIN2). We find that countries such as

Chile, Hungary, India, Israel, Philippines, the Slovak Republic and Thailand do not exhibit the

domestic variant of original sin, but do exhibit the international variety.

We explored seven theories to account for original sin. We find that the level of development is

not robustly correlated with international original sin, nor are the other correlates of development

such as institutional quality. In addition, we find scant relationship between capital controls and

measures of OSIN3. We also find weak support for the idea that monetary policy credibility and

fiscal solvency considerations are the correlated with original sin. While all countries with high

inflation have high measures of OSIN3, many countries with low inflation and public debt have

high measures of OSIN3. We also find that domestic financial development in terms of its size

relative to GDP or to the presence of foreign lenders is not robustly correlated with OSIN3. We

obtain a similar result for exchange rate regimes. The only variable that seems robustly related to

the international variant of original sin is the absolute size of the economy in the world, whether

measured by GDP, trade or total domestic credit. This suggests the presence of economies of

scale caused by liquidity or other factors. These results are based on cross-country regressions.

Exploiting the time series variation through fixed-effects panel-data estimation techniques

delivers similar results.


41/61

41

The domestic version of original sin was studied with a much smaller sample and the results are

consequently more tentative. However, in this case we find that size of the economy does not help

explain the phenomenon. We also find no evidence to suggest that measures of the level of

development or institutional quality are associated with the phenomenon. We find that monetary

credibility, as measured by lower average inflation, and the imposition of capital controls help

explain lower domestic original sin. Exchange rate flexibility is also negatively correlated with

domestic original sin although the relationship is not robust to the inclusion of capital controls.

We interpret this to mean that while countries that float tend to interfere more with capital flows,

once the controls are taken into account, there is no additional explanatory power in their

exchange rate choice.

While capital controls may be good for the reduction of domestic original sin, we found that

among the countries with low measures of this variable, capital controls were significantly higher

in countries with high international original sin. This suggests that the development of the

domestic market through capital controls is unelikely to do away with international original sin, at

least while the controls are present.

There are several problems with the empirical exercises performed in this paper. First of all, it is

not easy to find a measure of Original Sin that perfectly matches its definition. In particular, our

indexes only include securities and do not keep track of bank loans or other obligations.

Furthermore, in the domestic definition of Original Sin, we only focus on public debt. Second, our

sample of domestic Original Sin is small, consisting of only 22 countries. Third, our explanatory

variables are likely to be affected by measurement errors and hence our estimations are likely to


42/61

42

suffer from an attenuation bias. Fourth, some of our explanatory variables are likely to be

endogenous with respect to Original Sin.


43/61

43

References

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

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

Bayoumi, Tamim and Barry Eichengreen (1998), Optimum Currency Areas and Exchange Rate

Volatility: Theory and Evidence Compared, in Benjamin Cohen (ed.),International Trade and

Finance: New Frontiers for Research, Cambridge: Cambridge University Press, pp.184-215.

Bayoumi, Tamin and Barry Eichengreen (1998), Exchange Rate Volatility and Intervention:

Implications from the Theory of Optimum Currency Areas,Journal of International Economics

45, pp.191-209.

Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo (2000) "Hedging and Financial Fragility

in Fixed Exchange Rate Regimes" NBER Working paper 7143.

Calvo, Guillermo and Carmen Reinhart (2002), Fear of Floating, Quarterly Journal of

Economics.

Calvo, Guillermo and Pablo Giudotti (1990), Indexation and the Maturity of Government Bonds:

An Exploratory Model, in Rudiger Dornbusch and Mario Draghi (eds), Public Debt

Management: Theory and History, Cambridge: Cambridge University Press, pp.52-82.

Cspedes Luis Felipe Roberto Chang and Andrs Velasco (2002) "IS-LM-BP in the Pampas,"

unpublished manuscript, Harvard University

Chamon, Marcos (2001) "Why Can't Developing Countries Borrow from Abroad in their Own

Currency," unpublished manuscript, Harvard University


44/61

44

Chamon, Marcos and Ricardo Hausmann (2002) "Why Do Countries Borrow the Way They

Borrow," unpublished manuscript, Harvard University

Chang, Robert and Andrs Velasco (2000) "Banks, Debt, maturity, and Financial Crises,"Journal

of International Economics 51, pp.169-94

Chang, Robert and Andrs Velasco (2000) "Financial Fragility and the Exchange Rate Regime,"

Journal of Economic Theory 92, pp.1-34

Claessens, Stijn, Daniela Klingebiel, and Sergio Schmukler (2003) Government Bonds in

Domestic and Foreign Currency: The Role of Macroeconomic and Institutional Factors, CEPR

discussion paper No. 3789.

Corsetti, Giancarlo and Bartosz Mackowiak (2002) "Nominal Debt and Currency Crises,"

unpublished manuscript, Yale University

Cuikerman, Alex (1995), Central Bank Strategy, Credibility and Independence, Cambridge: MIT

Press.

Diaz-Alejandro, Carlos (1984), Stories of the 1930s for the 1980s, in Pedro Aspe Armella,

Rudiger Dornbusch and Maurice Obstfeld,Financial Policies and the World Capital Market,

Chicago: University of Chicago Press, pp.5-40.

Eaton, Jonathan and Mark Gersovitz (1981), Debt with Potential Repudiation: Theoretical and

Empirical Analysis,Review of Economic Studies 48, pp.289-309.

Eichengreen, Barry and Alan Taylor (2002), Monetary Consequences of a Free Trade Area of

the Americas, unpublished manuscript, UC Berkeley and UC Davis.


45/61

45

Flandreau, Marc and Nathan Sussman (2002), Old Sins: Exchange Clauses and European

Lending in the 19th

Century, unpublished manuscript, Sciences Po and Hebrew University.

Hausmann, Ricardo (2002) Good Credit Ratios, Bad Credit Ratings: The Role of Debt

Denomination, unpublished manuscript, Harvard University.

Hausmann, Ricardo, Ugo Panizza and Ernesto Stein (2001) Why Do countries Float the Way

They Float?Journal of Development Economics, 66: 387-414.

Honkapohja, Seppo and Pentti Pikkarainen (1992), Country Characteristics and the Choice of

Exchange Rate Regime: Are Mini-Skirts Followed by Maxi? CEPR Discussion Paper no. 774

(December).

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

International Monetary Fund

Kaufmann, D., A. Kraay and P. Zoido-Lobaton, 1999, Aggregating Governance Indicators,

World Bank Policy Research Working Paper 2195.

Kiyotaki, Nobu, Kiminori Matsuyama and Akihiko Matsui (1992), Toward a Theory of

International Currency,Review of Economic Studies 60, pp.283-307.

Kroszner, Randall (1999), Is it Better to Forgive than to Receive? Evidence from the Abrogation

of the Gold Clauses in Long Term Debt During the Great Depression, unpublished manuscript,

Graduate School of Business, University of Chicago.

La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (1997) "Legal

Determinants of External Finance"Journal of Finance 52, pp. 1131-1150.


46/61

46

Levy-Yeyati, Eduardo and Federico Sturzenegger (1999), "Classifying Exchange Rate Regimes:

Deeds vs. Words," unpublished, Universidad Torcuato di Tella.

Lucas, Robert and Nancy Stocky (1983), Optimal Fiscal and Monetary Policy in an Economy

Without Capital,Journal of Monetary Economics 12, pp.55-93.

Rose, Andrew (2002), One Reason Countries Pay Their Debts: Renegotiation and International

Trade, NBER Working Paper no.8853.

Rose, Andrew and Mark Spiegel (2002), A Gravity Model of Sovereign Lending: Trade, Credit

and Default, unpublished manuscript, University of California, Berkeley and Federal Reserve

Bank of San Francisco.

Tirole, Jean (2002) "Inefficient Foreign Borrowing," Invited Lecture, LACEA 2002

Wyplosz (2001), Financial Restraints and Liberalization in Postwar Europe,Financial

Liberalization: How Far? How Fast? in Gerard Caprio, Patrick Honohan and Joseph Stiglitz

(eds), Cambridge: Cambridge University Press.


47/61

47

Table 1: International bonded debt, by country groups and currencies

1993-1998

Total DebtInstruments

Issued byresidents

Total Debt InstrumentsIssued by residents in

own currency

Total debtinstrument issued in

groups currency

Share ofown

currency

Share ofgroups

currency

Major financial

centers

939.1 34% 493.6 64% 1868.4 68.1% 52.6% 199.0%

Euroland 855.9 31% 198.4 26% 647.5 23.6% 23.2% 75.7%

Other Developed

Countries

390.1 14% 68.6 9% 128.2 4.7% 17.6% 32.9%

Developing

Countries

269.0 10% 6.3 1% 16.8 0.6% 2.3% 6.3%

InternationalOrganizations

289.7 11% 0.0 0% 0.0 0.0% 0.0% 0.0%

ECU 0.0 0% 0.0 0% 82.8 3.0% 0.0% 0.0%Total 2743.7 100% 766.8 100% 2743.7 100.0% 27.9% 100.0%

1999-2001

Major financial

centers

2597.7 45% 1773.6 61% 3913.8 67.8% 68.3% 150.7%

Euroland 1885.6 33% 1071.5 37% 1722.2 29.8% 56.8% 91.3%

Other Developed

Countries

477.6 8% 45.9 2% 89.9 1.6% 9.6% 18.8%

Developing

Countries

434.0 8% 11.6 0% 47.4 0.8% 2.7% 10.9%

International

Organizations

378.4 7% 0.0 0% 0.0 0.0% 0.0% 0.0%

ECU 0.0 0% 0.0 0% 0.0 0.0% 0.0% 0.0%

Total 5773.3 100% 2902.5 100% 5773.3 100.0% 50.3% 100.0%Major financial centers: The US, Japan, the UK, and Switzerland

Source: Bank for International Settlements


48/61

48

Table 2: Measures of original sin by country groupings (simple average)

GroupOSIN1

1993-1998

OSIN1

1999-2001

OSIN3

1993-1998

OSIN3

1999-2001

WEIGTH**

1993-1998

WEIGTH**

1999-2001

Financial centers 0.58 0.53 0.07 0.08 0.20 0.35

Euroland 0.86 0.52 0.53 0.09* 0.36 0.45

Other Developed 0.90 0.94 0.78 0.72 0.56 0.53

Offshore 0.98 0.97 0.96 0.87 0.04 0.05

Developing 1.00 0.99 0.96 0.93 0.18 0.28

LAC 1.00 1.00 0.98 1.00 0.15 0.25

Middle East &

Africa

1.00

0.99

0.95 0.90 0.16 0.22

Asia & Pacific 1.00 0.99 0.99 0.94 0.22 0.33

Eastern Europe 0.99 1.00 0.91 0.84 0.28 0.37

* In the 1999-2001 period it is impossible to allocate the debt issued by non-residents in Euros to any of the individual member countries of the

currency union. Hence, the number here is not the simple average, but is calculated taking Euroland as a whole.* Weight is the share of bonded debt over total international debt (bonds plus bank loans).

Table 3: Countries with OSIN3 below 0.8, excluding Euroland and Financial centers1993-98 1991-01

Czech Republic 0.0 0.00

Poland 0.56 0.00

New Zealand 0.50 0.05

South Africa 0.27 0.10

Hong Kong 0.67 0.29

Taiwan 0.93 0.54

Singapore 0.96 0.70

Australia 0.56 0.70

Denmark 0.77 0.71

Canada 0.58 0.76


49/61

49

Table 4: Domestic Original Sin (Billion USD, end of 2001)Outstanding

Government Bonds

Domestic Currency Foreign

Currency

Total

GDP

Is the currency

convertible?

(1) (2)

DLTF

(3)

DSTF

(4)

DLTII

(5)

DLTIP

(6)

FC

(7)

LT fixed rate ST fixed

rate

ST or LT index

to interest rate

LT indexed

to prices

Argentina

7

NA 5.30 3.70 16.30 283.17 YesBrazil 340.00 27.20 193.80 98.60 751.5 No

Chile 5.00 4.09 0.51 7.10 3.89 67.469 Yes

Mexico 70.00 11.89 21.89 55.67 3.22 483.74 Yes

Venezuela 11.00 1.10 9.90 102.22 Not fully

Czech Republic1 10.50 4.20 6.00 53.111 Yes

Egypt8 NA 2.10 7.90 89.148 No

Greece8 NA 10.40 36.00 40.00 125.09 Yes

Hungary1 14.00 9.50 4.00 48.436 Yes2

Israel 24.00 7.40 6.90 9.70 0.03 100.84 Not fully

Poland1 29.00 20.50 8.80 155.17 Yes

Russia 6.00 401.44 No

Slovak Republic1 6.00 4.90 0.75 19.712 Yes

South Africa1 37.00 29.17 1.65 0.75 131.13 Yes

Turkey 88.00 12.60 43.50 31.00 185.69 Not fully

Hong Kong 14.00 5.31 8.71 158.94 Yes

India 130.00 125.60 4.70 447.29 Not Fully

Indonesia 50.00 7.20 43.30 142.51 No

Malaysia 33.00 6.60 27.21 79.039 No

Philippines 16.00 10.25 5.72 76.559 No

Singapore3 14.00 21.67 8.22 84.945 Yes

South Korea4 NA 406.94 Yes

Taiwan5 52.00 51.43 0.57 273 Yes

Thailand6 19.00 16.69 2.60 124.37 Not Fully

(1) There is a large Euromarket in the countrys currency, (2) since June 2001, (3) Singapore has USD 6.7 billion of corporate bonds, (4) South

Korea has the second largest (after Japan) fixed income market in Asia USD 9431 billion. (5) Taiwan has USD 34 billion of short-term paperissued by the government and private corporations, (6) Thailand has a marked of long-term corporate paper estimated at USD 12.7 billion, (7) The

data refers to 1998, (8) The data refers to 2000.


50/61

50

Table 5: Country Rankings According to Different Measures of

Domestic Original Sin

DSIN1 DSIN2 DSIN3

Mexico 0.000 Taiwan 0.011 Taiwan 0.011Venezuela 0.000 India 0.036 India 0.036

Czech Republic 0.000 South Africa 0.052 South Africa 0.076

Egypt 0.000 Slovak Republic 0.133 Slovak Republic 0.133

Greece 0.000 Thailand 0.135 Thailand 0.135

Hungary 0.000 Singapore 0.275 Singapore 0.275

Poland 0.000 Israel 0.288 Hungary 0.296

Slovak Republic 0.000 Hungary 0.296 Poland 0.300

South Africa 0.000 Poland 0.300 Philippines 0.358

Hong Kong 0.000 Philippines 0.358 Czech Republic 0.588

India 0.000 Chile 0.545 Hong Kong 0.621

Indonesia 0.000 Czech Republic 0.588 Israel 0.692

Malaysia 0.000 Hong Kong 0.621 Egypt 0.790

Philippines 0.000 Egypt 0.790 Mexico 0.872

Singapore 0.000 Mexico 0.837 Greece 0.880

Taiwan 0.000 Greece 0.880 Brazil 0.915Thailand 0.000 Brazil 0.915 Argentina 1.000

Israel 0.001 Argentina 1.000 Chile 1.000

Chile 0.250 Venezuela 1.000 Venezuela 1.000

Brazil 0.309 Turkey 1.000 Turkey 1.000

Turkey 0.356 Indonesia 1.000 Indonesia 1.000

Argentina 0.644 Malaysia 1.000 Malaysia 1.000

Table 6: Correlation between Domestic and International Original Sin

OSIN1 OSIN3 DSIN1 DSIN2 DSIN3

OSI

Mistery of Original Sin

Documents

Transcript of Mistery of Original Sin