Original sin redux and deviations from covered interest parity

Huanhuan Zheng

Journal of International Money and Finance, 2023, vol. 139, issue C

Abstract: Emerging markets (EMs) have increasingly turned to international capital borrowing in their local currencies (LC), leading to considerable LC external debts, particularly after the 2007 global financial crisis. Our study shows that this rise in LC external debts results in more significant deviations from the covered interest rate parity (CIP) between EMs and the US. This phenomenon is primarily attributed to a shift of currency mismatch risk and specific transaction costs from EM borrowers to international investors. As a result, EMs encounter elevated funding costs in comparison to the US, since investors seek higher returns to offset the added risks and expenses linked to LC external debts. Our analysis further underscores that the influence of LC external debts on amplifying CIP deviations is especially notable in EMs marked by substantial currency mismatch risks, such as those with floating exchange rate systems, heightened inflation risks, and significant currency depreciations. Moreover, the presence of stringent capital controls and limited debt market liquidity, which signify high transaction costs, intensify these effects.

Keywords: Covered interest rate parity; Original sin redux; Currency denomination; Sovereign debt; Capital controls (search for similar items in EconPapers)
JEL-codes: E43 F38 G15 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:139:y:2023:i:c:s0261560623001687

DOI: 10.1016/j.jimonfin.2023.102967

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