A Non-Deliverable Currency and Procyclical Capital Flows

Original sin is widely considered inevitable for emerging market economies on the ground that their currencies are not accepted as international currencies. Few, however, explore the effects of currency controls on original sin. To examine this possibility, I consider an open economy with a fully convertible currency and derive the following hypotheses. In the ideal state, banks combine cross-border cross-currency swaps with their offshore bond issuance to have currency exposures of the country be fully hedged. The resulting prevalence of the cross-currency swaps for hedging facilitate the flowing of long-term capital downhill—i.e., from a low-interest-rate economy to a high-interest-rate economy—without incurring currency mismatches. In the alternative state where the authority restricts offshore trading of the currency on prudential grounds, the financial landscape changes drastically. The currency risks will be systematically associated with foreign borrowings, so that debt capital inflows will build up currency mismatches and be followed by sudden reversals. By juxtaposing Australian and Korean data and analyzing a currency panel data set, I find supporting evidence for these hypotheses