In Search of the Origin of Original Sin Dissipation

Abstract

In this paper, we examine how, contrary to the ‘original sin’ hypothesis, emerging market economies have gained the ability to borrow abroad in their local currency. We identify three crucial conditions for the capacity to borrow in local currency: institutional quality, sufficient depth in the domestic bond market, and adequate performance in inflation targeting. We conduct a similar empirical analysis on portfolio equity, verifying that the depth of the equity market plays a key role in attracting foreign capital to domestic equity markets. Finally, we propose a simple portfolio model based on the inelastic market hypothesis to explain the positive correlation between capital market depth and the dissipation of original sin, which refers to the presence of more external liability in the form of equity or local currency debt. In essence, our analysis suggests that emerging market economies with reasonably strong fundamentals are not necessarily reliant on foreign currency debt.

Keywords: Original Sin, Local Currency Debt, Emerging Market