Foreign financing not a driver of emerging markets' currency woes
As a growing number of emerging markets teeter on the brink of crisis, we’re hearing more and more about “original sin”.
The concept, coined by economists Barry Eichengreen and Ricardo Hausmann, refers to the inability of most nations - and their corporations - to borrow abroad in their own currency. Instead, they necessarily borrow in other currencies.
Turkey, for example, has accumulated significant debts denominated in dollars. As the lira collapses relative to the dollar, those debts become harder to pay, fuelling a crisis and encouraging investors to flee, making a bad situation even worse.
On a superficial level, the degree to which a country exhibits original sin offers an appealing way to predict which economies are most vulnerable to crisis. After all, if a country relies on debt denominated in another country’s currency, it is necessarily vulnerable to collapse because of fluctuations in the exchange rate.
This conventional wisdom comes with a corollary. It holds that countries that exhibit high levels of original sin - in other words, are particularly reliant on foreign financing of long-term loans - must have some history of financial recklessness and instability that left them in this unenviable position. Heavy reliance on foreign financing suggests a history of trouble and a higher likelihood of future problems.
But history doesn’t really support this view. As two economic historians who studied the long history of original sin concluded, reliance on foreign financing of long-term debt does not in itself predict much of anything when it comes to the likelihood a country will sustain a financial crisis.
Prior to 1914, for example, many countries relied heavily on debt denominated in foreign currencies, or debt that contained a “gold clause” that effectively prevented borrowers from monetizing their debt. These countries, though ostensibly similar in terms of their reliance on foreign debt, did not necessarily end up in trouble.
In this particular study, for example, the researchers found that some countries with exceedingly high levels of original sin — the United States, for example, as well as South Africa, Norway, Finland, Uruguay and other countries — actually sustained far fewer crises than countries with lower levels of original sin: Argentina and Russia and other countries that the researchers delicately described as having “rotten fiscal institutions and poor international track records”.
In this early period, then, original sin did not really correlate with the likelihood of crises. But that was then. What about more recently? A separate survey in this same article that assessed levels of original sin in the 1990s offered a different but equally counterintuitive finding.
Here, countries with a troubled history had the same levels of original sin as countries with a sterling track record of repayment. Like the finding for the earlier era, this suggested that high levels of original sin had little to do with the likelihood of crises.
Conversely, low levels of original sin have not correlated with better performance, either. Separate studies have found emerging markets at the end of the 19th century - Argentina, Brazil, Chile, Italy and others - that managed to borrow heavily in international markets in their own currencies yet then defaulted.
Likewise, a separate study found that reliance on borrowing in other countries’ currencies has little correlation with a history of capital controls, lax monetary policy, problems with fiscal solvency, inflation levels and other hallmarks of trouble. The only variable that seems to be positively correlated with original sin is the size of the country: Smaller economies have higher levels of foreign borrowing. That’s it.
What does this all mean? History suggests that even if the current crisis in emerging markets plays out in the currency mismatches that come with borrowing abroad, this is a symptom, not an underlying cause. (Indeed, a sweeping study of sovereign debt found that the actual currency in which the debt is denominated does not seem to bear any relation to the likelihood of default.)
Instead, investors should pay far more attention to other problems afflicting these countries rather than reliance on foreign financing. No less importantly, low levels of foreign debt should not be construed as evidence of a low-risk environment. As one paper on the topic has noted, “minimising foreign currency financing is not a sufficient condition to eliminate financial crises.”
All of which is to say that investors should resist the understandable temptation to view foreign-denominated debt as a problem unto itself. It’s not — and never has been.