Original Sin Redux and Deviations from Covered Interest Parity

47 Pages Posted: 4 Sep 2020 Last revised: 24 Feb 2023

See all articles by Huanhuan Zheng

Huanhuan Zheng

National University of Singapore

Date Written: July 1, 2020


Abstract Emerging markets (EMs) have increasingly borrowed international capital in their local currency (LC) and built up sizable LC external debts, especially since the 2007 global financial crisis. We find that growing LC external debts enlarge deviations from covered interest rate parity (CIP) between EMs and the US. We further show that this is because LC external debts shift currency mismatch risk and certain transaction costs from EM borrowers to international investors, a phenomenon Carstens and Shin (2019) term “original sin redux”. Original sin redux drives up EMs' funding cost relative to the US' as investors require higher returns for bearing more risks and costs associated with LC external debts. This is supported by our findings that impact of LC external debts on widening CIP deviations is more pronounced in EMs with high currency mismatch risk, characterized by floating exchange regime, significant inflation risk and large currency depreciation, and with high transaction costs, indicated by tight capital controls and thin debt market liquidity.

Keywords: Covered interest rate parity, original sin redux, currency denomination, sovereign debt, capital controls

JEL Classification: E43, F38, G15

Suggested Citation

Zheng, Huanhuan, Original Sin Redux and Deviations from Covered Interest Parity (July 1, 2020). Available at SSRN: https://ssrn.com/abstract=3661239 or http://dx.doi.org/10.2139/ssrn.3661239

Huanhuan Zheng (Contact Author)

National University of Singapore ( email )

469C Bukit Timah Rd
NUHS Tower Block Level 7
Singapore, 259772

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