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Abstract
How has financial globalization changed the nature of external vulnerability of emerging economies? To answer this question, we first present an overview of the changes in international capital flows and cross-border stocks involving emerging economies from the 1970s to the COVID-19 crisis and then identify relevant recent shifts in financial globalization. We adapt the concept of currency hierarchy to the most recent features of financial globalization. We deploy a stylized balance sheet analysis to better understand the metamorphosis of these economies’ vulnerabilities. We find the occurrence of the phenomenon of ‘original sin’ during financial internationalization. In contrast, in more recent times of financial globalization, the diversification of financial flows and investors and the increase of securities denominated in domestic currency have created additional channels of vulnerability, labeled as ‘original sin redux’. We find that the private sector in Southern economies is mostly exposed to these new vulnerabilities. At first sight, it is good news because it preserves the fiscal space of Southern States in the case of capital outflows. However, it might create new contingent liabilities for the public sector. We call for capital account regulation in a broad sense to target these new complex vulnerabilities.
Acknowledgements
The authors are grateful to the anonymous referees for their valuable comments while exempting them from responsibility for any remaining errors and omissions. They also benefited from the discussions held at the FMM Conference and the AKB Conference, at the research colloquium for economics of Latin America at the Freie Universität Berlin as well as the seminars held at CEDEPLAR/UFMG, FINDE-UFF, IE/UFRJ, and IESP/UERJ.
Disclosure statement
The authors declare no conflict of interest. This article expresses the author’s opinion and does not necessarily represent the view of UNCTAD.
Notes
1 Here we define EMEs as peripheral or developing countries that have engaged in financial globalization in the 1990s. We will use EMEs and emerging economies as synonyms.
2 One exception is Kaltenbrunner and Painceira (Citation2015), who, following a Minskyan analysis, showed the changing nature of Brazil’s external vulnerability, in which the surging share of foreign investors in Brazilian assets shift the currency mismatch from domestic economic units to international financial investors, increasing the link between exchange rate movements to international market and funding conditions.
3 We make use of Milesi-Ferretti (Citation2022) database, that update data of Lane and Milesi-Ferretti (Citation2018) consolidating data extracted from IMF.
4 The contraction of world trade in 1981 caused the prices of primary resources (Latin America’s largest export) to fall. Considering the balance of payments of indebted countries due the effect of interest rate shocks on the stock of external debt, a handful of countries eventually became – using Minsky’s (Citation1986) taxonomy – Ponzi, namely they had to borrow to pay the debt service, in a situation that causes debt to escalate.
5 For a detailed analysis of capital flows to EMEs from a historical perspective, see Akyüz (Citation2011). On the boom phase of the third cycle of financial globalization, see World Bank (Citation2020) and López and Stracca (Citation2021).
6 This sequencing obviously entails regional and country-specific variation, which we cannot detail due to space constraints. The group of so-called ‘frontier markets economies’ of Sub-Saharan Africa and other poorer countries in terms of per capita income (IMF, Citation2019) certainly represents one of the major variations. Most of them entered into financial globalization during the third cycle (i.e. after the GFC) and to date they demonstrate a lower and less complex degree of global financial integration. For an analysis of the causes and consequences of the financial integration of frontier markets, see Prates et al. (Citation2023).
7 Another new feature of the third cycle of financial globalization is the increasing role of China as a creditor for peripheral countries. According to the World Bank (Citation2023), Chinese loans to low- and middle income-countries (LMIC) increased from 2012 and 2016 but have fallen sharply to an all-time low of US $5.4 billion in 2022. At the end of 2022, China accounted for 26.6% of the total external debt stock of LMICs. However, most of Chinese loans went to frontier-markets and other poorer developing economies not integrated in the global financial market. Therefore, although this is a key issue to understand the current debt challenges these economies are facing, it is beyond the scope of this paper that focuses on EMEs. On China’s expanding role in global finance, see Horn et al. (Citation2019).
8 On the impact of benchmark-driven funds on sovereign debt markets, see Cormier and Naqvi (Citation2023).
9 For a formalization of the relationship between liquidity preference and liquidity premium, see Ramos (Citation2019).
10 Most empirical studies confirm this spiraling dynamic between interest rate differential and currency appreciation, which violates the uncovered interest rate parity. This resulted in the emergence of one more puzzle in the mainstream literature on the determination of nominal exchange rates, the so-called forward premium puzzle (Brunnermeier et al., Citation2008), and the development of new models to explain it (De Grauwe & Grimaldi, Citation2006).
11 Eichengreen et al. (2023) point out, however, that the original sin persists in low-income countries as they have more difficulty in issuing domestic currency debt.
12 According to Bertaut et al. (Citation2023, p. 49), investors do not pre-hedge the currency risk when entering the local currency bond market as they aim to benefit from a stronger local currency even as the yields fall.
13 In this connection, Shin (Citation2023, p. 337) concludes that “those countries whose bonds are more sensitive to the fluctuations of the broad dollar index tend to pay higher nominal yields”.
14 We briefly explore this point in the conclusion, but it is beyond the scope of this paper to go into this issue in depth. For more on this issue, see Paula et al. (Citation2017).
15 For instance, Post-Keynesian Stock Flow Consistent models provide a simplified representation of real-world institutional configurations and feed them with statistical data to analyse and predict variables such as prices, quantities, or interest rates.
16 The term ‘emerging market’ was coined by an economist from the International Financial Corporation (IFC) – a member of the World Bank Group - in 1986 (Chancellor, Citation1999).
17 For the sake of simplification, we only assess financial flows and do not consider FDI. Against the neoclassical concept of households, here we distinguish between private households as wage earners without net financial wealth and investors who are net wealth owners.
18 This effect was particularly important during the debt crisis on developing countries in the 1980s as most syndicate loans had floating interest rates (Libor).
19 Calvo and Frenkel, key authors in analyzing the effects of the Latin American debt crisis, with special reference to Argentina, to describe the balance sheet effects of debt socialization in clear words, more than a decade before the concept of balance sheet effects entered the mainstream economic models: ‘Delinking the fortunes of debtor and creditor enterprises through debt socialization transforms the nature of debt and alters its risk characteristics without changing its magnitude. In socializing the debt, the government engages in debt-for-debt swaps in which government obligations (like treasury bills) are swapped for the claims that creditor firms and banks hold against [external] enterprises (…) to recapitalize creditor firms and banks. At the same time, the liabilities of debtor firms to other enterprises and banks are transformed into liabilities to the government’ (Calvo & Frenkel, Citation1991, p. 142). In the Argentinean context, Fanelli et al. (Citation1987) outline a scenario where a significant devaluation in 1981 was implemented to address capital outflows and acute external liquidity challenges. This move resulted in substantial balance sheet strain for Argentinean private firms and banks. Consequently, in 1982, a fiscal bailout was initiated, transferring the burden of foreign currency debt to the Argentinean State. This action triggered a profound fiscal crisis, compelling the Argentinean government to enter into an agreement with the IMF.
20 For the emergence of new actors, such as financial investors in manyfold forms, see French and Leyshon (Citation2004). The balance sheet analysis in this section supposes an emerging economy with full financial openness and permission for domestic financial transactions in (or denominated in) $N. For the sake of simplicity, it only includes transactions in spot markets, thus excluding financial derivatives.
21 After the financial crises of the 1990s, most EMEs adopted a dirty floating exchange rate regime in which the exchange rate is allowed to fluctuate, but the domestic central bank intervenes in the currency market either to curb the exchange rate volatility, to prevent it from trending in an unfavourable direction, or to accumulate foreign exchange reserves. However, the frequency and degree of intervention, as well as its specific objective, have varied across EMEs (BIS, Citation2013). Ilzetzki et al. (Citation2017) provides a comprehensive history of exchange rate arrangements for 194 countries and territories over 1946-2016, and found that the often-cited post-Bretton Woods transition from fixed to flexible arrangements is overstated; regimes with limited exchange rate flexibility remain in the majority.
22 The financial turmoil experienced by Brazil in 2020 serves as a compelling illustration of the resurgence of the original sin phenomenon: the domestic currency depreciated by 32.2% from March 3, 2020, to May 14, 2020. Concurrently, the IBOVESPA stock exchange index plummeted from 115 points on February 17, 2020, to 63 points on March 23, 2020 (Statista, Citation2024). Additionally, data from CEPAL reveals a staggering 35.4% decline in foreign capital inflows in 2020 compared to the previous year, amounting to approximately US$24 billion (CNN Brasil, Citation2022). Many emerging market economies (EMEs) heavily reliant on international investments in their domestic currencies faced similar challenges during the COVID-19 crisis, with Brazil being among the hardest hit. Without the decisive interventions of central banks in advanced economies worldwide, the Brazilian central bank would have been compelled to dramatically increase the policy rate in 2020, resulting in amplified borrowing costs for domestic investors, exacerbating liquidity and solvency concerns.
23 In financial globalization, investors get on debt to buy securities in search for capital gains greater than the debt service costs.
24 In contrast, if there are also Treasury bonds indexed to the policy rate, there is a direct negative balance sheet effect for the Treasury as monetary tightening by the Southern Central Bank will raise debt service costs.
25 OMO can be either outright operations (definitive sell or purchase) or repurchase agreements (repos and reverse-repos); see more on this in Bindseil (Citation2004).
26 The institutional framework governing the relationship between central bank and treasury can take various forms and differs across countries (i.e. Blommestein & Turner, Citation2013). The IMF sets as ‘good practice’ the Central Bank transferring gains and losses to the Treasury (Pessoa & Williams, Citation2013).
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Luiz Fernando de Paula
Luiz Fernando de Paula is Professor of Economics at the Federal University of Rio de Janeiro (IE/UFRJ) and University of the State of Rio de Janeiro (IESP/UERJ), Brazil; Researcher of National Council for Scientific and Technological Development (CNPq), Brasilia and Foundation for Supporting Research in the State of Rio de Janeiro (FAPERJ), Rio de Janeiro, Brazil
Barbara Fritz
Barbara Fritz is Professor of Economics at the Institute for Latin American Studies and School of Business & Economics, Freie Universität Berlin, Germany
Daniela Prates
Daniela Prates is Senior Economic Affairs Officer at the United Nations Conference on Trade and Development (UNCTAD), Geneva, Switzerland. This article expresses the author’s opinion and does not necessarily represent the view of UNCTAD.