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Original sin redux and deviations from covered interest parity

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  • Zheng, Huanhuan

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.

Suggested Citation

  • Zheng, Huanhuan, 2023. "Original sin redux and deviations from covered interest parity," Journal of International Money and Finance, Elsevier, vol. 139(C).
    • Handle: RePEc:eee:jimfin:v:139:y:2023:i:c:s0261560623001687
    DOI: 10.1016/j.jimonfin.2023.102967
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    Cited by:

    1. Maeng, F. S., 2024. "Default, Inflation Expectations, and the Currency Denomination of Sovereign Bonds," Cambridge Working Papers in Economics 2438, Faculty of Economics, University of Cambridge.

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    More about this item

    Keywords

    Covered interest rate parity; Original sin redux; Currency denomination; Sovereign debt; Capital controls;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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