[Song Seungseop's Financial Light] The Guilt of Not Being a Key Currency Country: "Beware of Foreign Capital Outflow"

Emerging Markets Suffering from Foreign Capital Outflow Risks
Possibility of Capital Outflow Remains Despite Bond Market Development
Korea Faces Similar Outflow Risks as Emerging Markets
"Continuous Budgeting for Currency Risk Management Should Be Considered"

Photo by Asia Economy DB

Have you ever heard the term "original sin"? It first appears in the Bible's Book of Genesis. It refers to the sin that arose when the first humans, Adam and Eve, ate the forbidden fruit. In Christian thought, since humans committed an act forbidden by God, they are born inherently sinful. Interestingly, the term "original sin" is also used in economics. It refers to countries that are not issuing the global reserve currency. Why do economists point out that non-reserve currency countries have an original sin?

The original sin of non-reserve currency countries is a term used particularly in the field of international finance within economics. It refers to the problems these countries inherently face because they are not reserve currency issuers. It is especially used to highlight the risks faced by emerging markets such as developing countries. The core idea is that when global financial conditions worsen, emerging markets that are not reserve currency countries always face the risk of a sudden outflow of foreign investment funds. This concept was first mentioned in a 1999 study by renowned economists Barry Eichengreen and Ricardo Hausmann.

Emerging Markets Without Reserve Currency... Anxious About Foreign Capital Flight

The amount of government bonds issued as of early this year in 14 emerging countries including Saudi Arabia, Hungary, Romania, Indonesia, the Philippines, and Mexico.

Here is their explanation. Emerging markets need massive capital to become developed countries. To do so, they must attract foreign investors with strong financial power. To achieve this, developing countries try to issue many bonds denominated in their own currency. However, foreign investors often respond coldly. You wouldn’t invest in bonds denominated in the currency of a country you hardly know, right? Investors think the same way.

Since it is difficult to issue bonds denominated in their own currency despite the need for funds, these countries rely on foreign debt. This means borrowing in dollars, often through very short-term external debt. Of course, when the economic situation is normal, short-term external debt is not a burden. Even when bond maturities approach, extensions are usually granted. The problem arises during recessions. When international financial conditions deteriorate, investors withdraw the dollars they invested. If the exchange rate soars, the burden of foreign debt increases.

Is there a way to eliminate this original sin? At first glance, the solution seems simple. Developing the domestic currency bond market would help. By following advice from the International Monetary Fund (IMF) or the Organisation for Economic Co-operation and Development (OECD), improving economic fundamentals, raising economic growth rates, and abolishing unreasonable regulations to increase investment attractiveness, more investors would be willing to invest in bonds despite some risks, seeing future growth potential.

Even with Bond Market Development, Emerging Markets’ 'Original Sin' Remains

Barry Eichengreen and Ricardo Hausmann

However, recent research by economists shows that this is not the case at all. Eichengreen, Hausmann, and others published a paper last year titled "The Persistence of Original Sin." The main point was that since the 2000s, emerging markets have improved macroeconomic policy capabilities, economic indicators have improved, and domestic currency bond markets have developed. However, when major central banks adopted tightening policies in 2013, bond markets either regressed or stagnated.

Agustin Carstens, former governor of the Bank of Mexico in 2019, and Shin Hyun-song, a professor at Princeton University, made similar claims. They viewed the development of domestic currency bond markets and the resulting inflow of foreign investors and reduced foreign debt burden positively. However, they pointed out that since foreign investors invested in foreign currency rather than dollars, they were exposed to exchange rate risk. If exchange rates fluctuate sharply, foreign investors could suddenly withdraw their funds. These economists called this phenomenon the "return of original sin." Emerging markets thought the problem would be solved by developing bond markets, but the risk of sudden capital flight remains significant.

Does this really happen? Economists examined actual cases. Observing the COVID-19 period, when the global economy fluctuated drastically, they found the anticipated side effects emerging one after another. Data on American investors showed a tendency to sell bonds denominated in emerging market currencies as exchange rates rose. In the first quarter of 2020, when the COVID-19 shock began, foreign investment in emerging market bonds denominated in local currencies dropped sharply by $20 billion.

"South Korea Cannot Be Complacent, Should Consider Regular Budgeting for Exchange Rate Risk Management"

On the 12th, the dealing room of Hana Bank headquarters in Myeongdong, Jung-gu, Seoul [Image source=Yonhap News]

South Korea also faces the same original sin. Although it is one of the top ten largest economies globally, it is not a reserve currency country and is classified as an emerging market. Especially as a small open economy, South Korea is vulnerable to external factors, and its foreign exchange market has been criticized as a "playground for speculators."

Experts say it is not a situation to be complacent about. Although the risk of a sharp rise in the exchange rate is not high, the interest rate gap between South Korea and the United States has widened to historic levels, and with market predictions difficult, the possibility of a temporary rise in the won-dollar exchange rate cannot be ruled out. Song Min-ki, a research fellow at the Korea Institute of Finance (KIF), explained, "In South Korea’s case, as the won-denominated bond market develops, foreign investors bear exchange rate risk. If difficulties arose due to increased exchange rate volatility in the second half of last year, it is necessary to shift risk awareness and improve management systems, such as considering the regular budgeting of exchange rate risk management funds."

*(Reference) This article was written with reference to "The Unpredictability of Exchange Rates and the Return of Original Sin in Non-Reserve Currency Countries (Research Fellow Song Min-ki)" published in Volume 32, Issue 09 of the Korea Institute of Finance Financial Brief.

Editor's NoteFinance is difficult. It involves confusing terms and complex backstories intertwined. Sometimes, you need to learn dozens of concepts just to understand one word. Yet finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even those with no financial knowledge can immediately understand these "light" stories that illuminate the world of finance.