How original sin affects India

Original sin, once just a Christian doctrine, has now become an economic concept too thanks to economists like Barry Eichengreen, Ricardo Hausmann, Panizzi and Roberto Rigobon.

It refers to the inability of developing countries like India to raise foreign loans in their own currencies. The ONGC, for instance, can raise foreign loans designated in dollars but not in rupees. Why?

Because financial markets distrust Third World currencies. Too many Third World countries have used inflationary policies to reduce the real value of their debt.

Now, this looks irrelevant for prudent countries. India has kept inflation below 10% for five decades. Chile’s Unidades de Fomento (UF) bonds index local currency to inflation, guaranteeing their real value. Yet global markets remain reluctant.

The “original sin” of historically profligate Third World governments seems to taint their successors.

It matters greatly to developing countries whether foreign debt is denominated in dollars or local currency. In a recent paper (IDA in UF by Ricardo Hausmann and Roberto Rigobin, World Bank 2003), Hausmann and Rigobon show that dollar designation seriously exacerbates the stability of output, volatility of capital flows, creditworthiness, fiscal and external solvency.

Solution? Hausmann and Rigobon say that IDA, the soft-loan window of the World Bank, should designate loans in a basket of inflation-indexed Third World currencies, or UFs (following Chile’s Unidades de Fomento). The World Bank itself borrows in hard currencies to finance middle-income countries, and so needs to designate its loans in the same hard currencies. But IDA money for poor countries comes in the form of outright grants from donors, and could in principle be designated in any currency, including UFs.

Hausmann and Rigobon show that the volatility of GDP growth is far higher in developing countries than developed ones. The volatility of the real exchange rate is 61.2% in developing countries against 18.1% in developed ones.

This worsens the capacity to pay in a crisis. In Indonesia in 1998, GDP fell 7% in local currency but 60% in dollars. In Nigeria in 1999, GDP fell only 2% in local currency terms but 74% in dollars.

This explains why Brazil, Argentina, Turkey and Mexico have public debt/GDP ratios comparable with those of the United States, Canada and Spain, yet have radically different credit ratings. Exchange rate volatility makes them more risky.

IDA’s rate of interest looks very low. But in the Asian financial crisis, Indonesia’s exchange rate went from 2,200 to 17,000 rupiahs to the dollar, so even an IDA loan carrying less than 1% interest suddenly became onerous to service. Worse, the exchange rate shock came when the country was already deep in financial trouble, exacerbating the business cycle. The authors calculate that if all IDA funds are designated in UFs, volatility drops dramatically.

The standard deviation of exchange rate fluctuation falls to just 3.49 for the IDA countries as a whole, against 15.8 for individual countries. Note that the standard deviation for the dollar-Deutsche mark exchange rate averaged over 12 in 1980-2000! So, huge potential gains can be achieved by UFs.

A simulation done by the authors tests what would have happened if IDA had been designated in UFs in 1980-2000. First, contrary to market fears, UFs would have protected lenders. Reflows (interest and principal payments) matter not only for lenders but for solvent borrowers like India: reflows constitute a significant proportion of funds recycled into fresh lending by IDA. The authors find, remarkably, that to keep reflows constant, IDA’s interest rate would have had to be raised only marginally from 0.724% to 0.812%. Many Third World currencies depreciated dramatically in this period, but those of successful countries like South Korea appreciated.

Have all the best borrowers with appreciating currencies (like South Korea) graduated out of IDA? Yes, but new successes like India are taking their place. Remember, Goldman Sachs’ famous BRIC report projects that the rupee will appreciate 2.5% annually. The actual appreciation in the last year has been even faster. Many Asian countries (including China, South Korea, Taiwan and Thailand) are trying to check currency appreciation to aid their exporters, yet this seems only to put off the inevitable. Let’s face it: many developing country currencies will appreciate in coming years.

The impact of UFs on recipients is hugely beneficial because their debt/GDP ratio becomes less pro-cyclical. Countries get into trouble when their debt/GDP and interest/GDP ratios suddenly rise. The rise is moderated greatly if IDA loans are designated in UFs and not dollars. So, UFs provide good insurance cover in an economic downswing. Recessions and devaluations tend to ratchet down in a vicious cycle in low-income countries. UFs can help break that pro-cylical tendency.

The Hausmann/Rigobon proposal seems to me an eminently workable and worthwhile one. Let us be clear about the concept. It does not provide any subsidy to indebted countries. Rather, it provides insurance to all IDA borrowers by pooling their currency risks. Some developing-country currencies will appreciate and some will depreciate, but nobody can be certain in advance: too many high fliers have later collapsed. Right now there is no global market for bonds in Third World currencies. Pooling currency risk through UFs can create this missing market. It requires no subsidies or great political will. It is eminently do-able.

Among IDA recipients, China and India seem most likely to have appreciating currencies. Yet the uncertainties ahead are such that both would probably welcome IDA loans in UFs rather than dollars. India and China are pre-paying some World Bank loans on the ground that the interest rate is high by today’s standards. But if they were confident about currency appreciation, they would conclude that the “high” interest rate was illusory since it would be more than offset by a depreciating dollar. Clearly neither country is willing to make a big bet on currency appreciation. And if they welcome IDA loans designated in UFs, so will other borrowers. India should support the Hausmann/ Rigobon scheme. It will finally end the curse of original sin.

What do you think?