[PEN-L:32611] Eichengreen and Hausmann on EM Index

[Michael Pollak <mpollak@xxxxxxxxx>]

[I assume these two probably lay this idea out in a longer paper
somewhere.  Does anyone know where I can find it?]

Financial Times; Nov 22, 2002

COMMENT & ANALYSIS: How to eliminate original financial sin

By Barry Eichengreen and Ricardo Hausmann

Despite the best efforts of the international financial architects, the
problem of emerging market crises is not going away. When a country is hit
by a piece of bad news or a bout of political uncertainty - as Brazil was
recently - investors sell off their assets and the currency plummets. If
this were all that happened, the main effect would be more competitive
exports and the crisis would solve itself. But since so much of
emerging-market debt is denominated in foreign currency, this produces a
massive increase in debt-servicing costs. Fears of payment difficulties
create a vicious circle.

The core of this phenomenon is that countries cannot borrow abroad in
their own currency: external debt is overwhelmingly denominated in foreign
currency. In the period 1999-2001 developing countries accounted for 8 per
cent of the debt but less than 1 per cent of the currency denomination.

Some would say this is so because the policies and institutions of many
countries lack credibility. But this phenomenon is not peculiar to
developing countries with weak policies and institutions. It affects
virtually all countries except the issuers of the five main currencies. It
affects countries with low inflation, balanced budgets and a reliable rule
of law. Since it is not clear what countries have done to bring this
problem upon themselves, it is referred to as "original sin".

What accounts for the concentration of the world's debt portfolio in a few
currencies?  For countries to be able to borrow abroad in local currency,
the foreign investor - the proverbial Belgian dentist - must take a long
posi tion in local currency. But it is hard to imagine the dentist
managing a port-folio that includes the currencies of many small
economies. Each additional currency adds an opportunity for
diversification but it also adds costs and risks. The optimal portfolio
will thus have a limited number of currencies.

Countries consequently face an uphill battle when seeking to add their
currencies to the global basket. Those that succeed will make it harder
for competitors: investors will have even less appetite for additional
exotic currencies. Thus, the problem of original sin is not merely a
problem of inadequate national policies. It is a problem with the
international system that requires an international solution.

We propose a unit of account - the EM index - based on a diversified set
of emerging- market and developing-country currencies. This unit would
represent claims on a more diversified economy and hence would be more
stable, since shocks such as changes in export prices that are positive
for some economies will be negative for others. Each currency in the
basket would be indexed to the country's inflation rate to protect
investors from the borrower's temptation to debase it. Historically, this
basket has shown low volatility, making it attractive to investors.

The World Bank and the other international financial institutions (IFIs)
should start issuing debt in the EM index. Their AAA rating allows them to
access institutional investors and should create sufficient liquidity to
make the bonds easily tradable.

The IFIs will find it easy to get rid of the currency mismatch caused by
issuing EM- indexed bonds. They can simply convert the dollar loans they
have made to the countries in the index into local currency CPI-indexed
loans. They will thereby eliminate the currency mismatch generated through
their own lending, and become a solution for instead of a source of
original sin.

Other high-grade issuers will then be able to develop the market further.
The governments that issue the five main currencies are the natural
candidates to issue additional high-grade EM-indexed debt. They too are
low-risk, AAA-rated borrowers. And they have an interest in eliminating
the global instability created by original sin.

Of course, the industrial countries will not want to expose themselves to
a currency mismatch. They will want to swap their currency exposure with
the emerging markets. But, precisely by doing so, they will allow the EMs
to offload their currency risk. In fact, it has been through foreign
issuers - mainly IFIs - and the swap market that a few lucky countries
such as Poland, South Africa and New Zealand have escaped original sin.

The standard recipe of macro-economic prudence and institution-building
will not do away with original sin any time soon but promoting the EM
index market could do it.

The writers are professors of economics at Berkeley and Harvard
respectively