Original Sin Redux and Deviations from Covered Interest Parity

Abstract

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