Sign up for our newsletter to receive regular updates on currency news. One of the most positive global development stories in recent years has been the improvement of “original sin,” as economists Barry Eichengreen, Ugo Panizza, and Ricardo Hausmann referred to the dangerous reliance on foreign-currency borrowing in emerging markets. Thanks to the establishment of strong local bond markets in many major developing countries, this vulnerability has been reduced, if not completely eliminated. This progress is evident today, as we see that interest rate hikes from the Federal Reserve, which would have previously caused significant damage to emerging markets, now only affect a few smaller countries rather than those of systemic importance like Mexico or South Korea.
However, the Bank for International Settlements (BIS) has argued that while original sin has evolved, it has not been completely eliminated. According to Agustín Carstens and Hyun Song Shin of the BIS, along with other researchers, the risk of currency mismatch has shifted from borrowers to lenders. International investors who buy local-currency bonds in countries like Ghana are now exposed to the risk of volatile currency movements. Furthermore, the recent trend in emerging markets of borrowing at longer maturities to take advantage of high yields has introduced duration risk, or the sensitivity of longer-term bonds to interest rates, into the analysis. This combination of duration and currency risks has become a significant factor in market dynamics.
The findings of the research emphasize the importance of duration risk in emerging market sovereign bonds. By issuing longer-term bonds, borrowers mitigate the risk of refinancing their debt, but investors face greater sensitivity to yield changes. Fluctuations in market values due to duration risk, along with currency risk, create a “wind chill” effect that impacts investors and amplifies market shocks. Mutual funds, in particular, exhibit high sensitivity to financial conditions, leading to significant changes in their holdings of local currency bonds. Other investor sectors, on the other hand, display lower sensitivity and maintain more stable portfolios.
Additionally, the study highlights shifts in the investor base in emerging market capital markets. Despite the progress made in overcoming original sin by issuing local currency sovereign bonds, foreign investor flows have decreased. Domestic investors have absorbed most of the sell-off of local currency bonds by foreign investors. This dependence on domestic investors, coupled with the fact that a significant portion of new sovereign debt issuance ends up on domestic bank balance sheets, has increased the government’s reliance on domestic investors for fiscal space.
Overall, the findings challenge the notion that emerging market vulnerabilities are solely due to borrowing in foreign currency. They also suggest that longer maturity debt does not alleviate vulnerabilities but instead introduces new risks associated with market fluctuations. While borrowing in domestic currency may not be a complete solution, it is a step towards risk reduction. The improvement in emerging markets over the past few decades can be attributed in part to addressing the original sin identified by Hausmann, Panizza, and Eichengreen.
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