How to Understand the Mystery of Original Sin in Finance

Key takeaways:

• Original sin in finance is the inability of emerging market economies (EMEs) to borrow abroad in their own currencies, which exposes them to exchange rate risk and financial instability.
• Original sin dissipation (OSD) is the gradual increase in foreign investments in local currency bonds in EMEs, which reduces their exposure to exchange rate risk and enhances their financial resilience.
• Capital market depth, inflation-targeting performance, and shares in the GBI-EM Index are the three main factors that determine the capacity to borrow in local currency.

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Backdrop

If you are interested in finance, you may have heard of the term “original sin” before.

But what does it mean, and why is it important for emerging market economies (EMEs)?

In this blog post, we will explain the concept of original sin in finance, how it has evolved, and what factors have contributed to its dissipation. We will also share some insights from a recent IMF working paper that explores the relationship between capital market development, monetary policy credibility, and original sin dissipation.

By the end of this post, you will have a better understanding of this complex and fascinating topic, and how it affects the global financial landscape.

What is Original Sin in Finance?

Original sin in finance is not a religious concept, but rather an economic one. It was first introduced by Eichengreen and Hausmann (1999) to describe the situation where peripheral economies, such as EMEs, cannot borrow abroad in their own currencies. Instead, they have to rely on foreign currency debts, which expose them to exchange rate risk and financial instability. For example, if the local currency depreciates against the foreign currency, the debt burden increases and the debt service becomes more difficult. This can trigger a vicious cycle of currency crises, capital outflows, and economic contraction.

The term “original sin” implies that this situation is not a result of poor policies or institutions, but rather a deep-rooted structural problem that is beyond the control of individual countries. Eichengreen and Hausmann (1999) argued that only the size of the economy matters for the ability to borrow in local currency, and that larger economies enjoy this privilege while smaller ones do not. They also claimed that there is no clear theory that can explain this phenomenon, leaving it as a mystery.

How Has Original Sin Evolved Over Time?

Since the introduction of the original sin concept, there have been significant changes in the global financial architecture that have challenged its validity. In particular, since the mid-2000s, there has been a steady growth in foreign investments in local currency bonds in EMEs, indicating a dissipation of original sin. This means that EMEs have gained the ability to borrow abroad in their own currencies, reducing their exposure to exchange rate risk and enhancing their financial resilience.

Several studies have documented and explained this trend of original sin dissipation (OSD). For example, Burger and Warnock (2003, 2006) showed that EMEs with stronger institutions and better inflation performance have larger local currency bond markets. Arslanalp and Tsuda (2014) and Han (2022) provided data on local currency bonds held by foreign investors and confirmed the gradual OSD since the mid-2000s. Eichengreen et al. (2022) argued that OSD is still limited to sovereign bonds and does not apply to most frontier market economies.

What Factors Have Contributed to Original Sin Dissipation?

In this section, we will share some insights from a recent IMF working paper by Han, Lee, and Oh (2024) that empirically investigates the factors associated with OSD. The paper uses a newly constructed dataset that separately identifies local currency and foreign currency debts in EMEs, and covers 21 EMEs from 2005 to 2019. The paper also proposes a theoretical model that explains the key empirical findings.

The paper finds that three factors are crucial for the capacity to borrow in local currency: capital market depth, inflation-targeting performance, and shares in the JP Morgan Government Bond Index-Emerging Markets (GBI-EM). Let’s look at each of these factors in more detail.

Capital Market Depth

Capital market depth refers to the size and liquidity of the domestic bond market, measured by the ratio of public bonds outstanding to GDP. The paper shows that capital market depth is positively and strongly correlated with local currency debt, meaning that larger bond markets attract more foreign investments. This makes sense, as larger markets offer more diversification, lower transaction costs, and higher returns for foreign investors.

The paper also suggests a theoretical explanation for this relationship, based on the concept of inelastic demand, inspired by the inelastic market hypothesis (IMH) introduced by Gabaix and Koijen (2021). The idea is that when global investors sell their holdings due to global shocks, such as US monetary policy shocks, local investors have a limited capacity to absorb the sell-off, leading to a drop in asset prices. The magnitude of the price drop depends on the share of global investors in the market: the higher the share, the larger the drop. Therefore, assets in markets with higher shares of global investors are less attractive, as they have poor risk-hedging properties. Conversely, assets in markets with lower shares of global investors are more attractive. This implies that an EME with a larger capital market can attract more foreign capital, as it can accommodate a lower share of global investors and offer better risk-hedging properties.

Inflation-Targeting Performance

Inflation-targeting performance refers to the credibility of monetary policy, measured by the deviation of realized inflation from the inflation target. The paper shows that inflation-targeting performance is negatively and significantly correlated with local currency debt, meaning that lower deviations from the target imply higher local currency debt. This also makes sense, as lower deviations from the target signal a more disciplined and credible monetary policy, which reduces inflation risk and exchange rate volatility, and increases the attractiveness of local currency assets for foreign investors.

The paper also aligns with previous theoretical studies that emphasize the importance of monetary policy credibility and stable inflation in facilitating borrowing in local currency

Shares in the GBI-EM Index

Shares in the GBI-EM Index refer to the weight of each EME in the index, which is a widely used benchmark for local currency bond investments in EMEs. The paper shows that shares in the GBI-EM Index are positively and significantly correlated with local currency debt, meaning that higher shares imply higher local currency debt. This can be explained by the presence of passive funds that track the index, or by the information effect of the index, which informs global investors about the existence and quality of local currency bond markets.

The paper also confirms the significance of the GBI-EM Index in determining the size and composition of inflows into various EME local currency bond markets.

Conclusion

In this blog post, we have explained the concept of original sin in finance, how it has evolved over time, and what factors have contributed to its dissipation. We have also shared some insights from a recent IMF working paper that explores the relationship between capital market development, monetary policy credibility, and original sin dissipation. We hope that this post has helped you understand this complex and fascinating topic, and how it affects the global financial landscape.

Here are the main points to remember:

• Original sin in finance refers to the inability of peripheral economies, such as EMEs, to borrow abroad in their own currencies, which exposes them to exchange rate risk and financial instability.
• Original sin has dissipated since the mid-2000s, as EMEs have gained the ability to borrow abroad in their own currencies, reducing their exposure to exchange rate risk and enhancing their financial resilience.
• Three factors are crucial for the capacity to borrow in local currency: capital market depth, inflation-targeting performance, and shares in the GBI-EM Index.
• Capital market depth is positively and strongly correlated with local currency debt, as larger bond markets offer more diversification, lower transaction costs, and higher returns for foreign investors, and also provide better risk-hedging properties against global shocks.
• Inflation-targeting performance is negatively and significantly correlated with local currency debt, as lower deviations from the target signal a more disciplined and credible monetary policy, which reduces inflation risk and exchange rate volatility, and increases the attractiveness of local currency assets for foreign investors.
• Shares in the GBI-EM Index are positively and significantly correlated with local currency debt, as higher shares imply higher local currency debt, due to the presence of passive funds that track the index, or the information effect of the index, which informs global investors about the existence and quality of local currency bond markets.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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