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Currency and Maturity Mismatching Redeeming
Debt from Original SinWashington, DC. November
21 and 22, 2002

• A fiscal perspective on
• currency crises and the original sin
• Giancarlo Corsetti
• University Rome III, Yale and CEPR
• and
• Bartosz Mackowiak
• University of Humboldt

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The fiscal dimension of currency and price
instability
Why do countries find it so hard to issue
non-indexed debt in local currency? There are
different answers but a recurrent theme
governments have an incentive to engineer
inflation for fiscal purposes. The traditional
view stresses seigniorage revenues. But data
shows that seigniorage is low in crisis episodes.
Most important, new theories stress an
alternative view of fiscal gains from inflation
wealth transfers between the private and public
sector via a fall in the real value of nominal
public liabilities.
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Fiscal imbalances and currency crises a
framework
This paper presents a framework to study currency
and price instability associated with a fiscal
imbalance. The focus is on the attributes of the
stock of government liabilities that foster, or
prevent, fiscal adjustment in the face of real
and nominal shocks, via balance sheet effects.
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Public liabilities

• We consider both implicit and explicit
  liabilities, allowing for difference in
• Size
• Maturity
• Currency denomination or more generally
  indexation
• Liabilities may include pensions, transfers, but
  also public sector wages.

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Relation to the theory of currency crises

• Fiscal roots of exchange rate collapses are of
  course a classic theme in the theory of currency
  crises.
• In the seminal contributions by Krugman (1979)
  and Flood and Garber (1984), public liabilities
  play no role these contributions are clearly
  motivated by fiscal considerations, but they
  stress a monetary mechanism. No balance sheet
  effects there.
• In more recent literature, the currency and
  maturity structure of public liabilities are seen
  as determinants of currency crises only insofar
  as they affect international liquidity.

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A simple intuition

• Lets consider the same experiment of Krugman and
  Flood and Garber in a fixed exchange rate
  regime, there is an unexpected decrease in the
  present value of government's primary surpluses
  relative to the real value of the current stock
  of public liabilities.
• The first-generation authors would map the fiscal
  imbalance into a seigniorage target for the
  monetary authority. But why stopping here?
• If some of the public liabilities are not indexed
  to price or exchange rate movements, exchange
  rate depreciation and/or a fall in public bond
  prices will result into a wealth transfer to the
  government, that contribute to finance the fiscal
  imbalance.

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Main policy implications

• The first is on vulnerability to foreign shocks
• fiscal imbalances derive not only from
  deterioration of primary surpluses, but also from
  nominal shocks abroad.
• Foreign deflation drives the domestic price level
  down, thus raising the real value of non-indexed
  public debt.
• Second, nominal liabilities acts as a cushion for
  a government at a time of a crisis
• devaluations are larger when foreign-currency or
  indexed (real) debt is a higher fraction of total
  public debt.

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Main policy implications

• Third, exchange rate and price adjustment is
  nonlinear in the fraction of indexed (dollar)
  debt
• In equilibrium, small differences in the degree
  of dollarization can generate large difference in
  the rate of depreciation/inflation.
• Fourth, nominal long-term liabilities helps delay
  devaluation
• Prices of long-term bonds fall in anticipation of
  future devaluation, decreasing the real burden of
  public debt. The option to avoid an immediate,
  sudden devaluation requires that long-term
  nominal debt be of sufficient size relative to an
  imbalance.

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Main policy implications

• Fifth, seigniorage does not necessarily play any
  role in financing the imbalance.
• To illustrate this most clearly, in our
  devaluation scenario none of the imbalance is
  financed by anticipated money growth.
• Monetary policy still matters, though. Through
  its effects on current prices of government
  liabilities, a policy that delivers low long-run
  inflation increases the one-time adjustment in
  the exchange rate at the time of the crisis. Low
  chronic inflation is consistent with a one-time
  devaluation of dramatic size.
• Moreover, constraint on interest rate may
  determine the timing of price and exchange rate
  adjustment.

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So

• The original sin
• Has important consequences for fiscal
  flexibility foreign currency borrowing and short
  term borrowing erodes the basis of an important
  automatic mechanism of adjustment to fiscal
  shocks.
• May be caused by the presence of such mechanism
  the government has a strong temptation to let
  inflation drift, engineering large saving.

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Outline of the model

• Small open economy, single representative agent
• Endowment of traded (and non traded) goods
• Law of one price holds for tradables
• Government issues short-term nominal bond, and
  nominal perpetuities.
• Households hold government debt and a shot-term
  default-free international bond.
• Important simplifying assumption
• Government debt is held exclusively by domestic
  private agents. We abstract from default risk.

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Price and exchange rate stability requires a
fiscal discipline and flexibility
Conditional on the initial stock of debt,
define?? as any sequence of primary surpluses at
which the budget constraint of the government
holds with permanent price and exchange rate
stability

• where L and B are long-term and short-term debt.
  F is debt denominated in foreign currency.
• In response to shocks hitting the economy, policy
  must set a sequence of primary surpluses so as to
  insure that they fully back debt (referred to as
  passive or Ricardian fiscal policy in the
  literature).

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The experiment

• A passive fiscal policy is a convenient
  starting point for our analysis. Given ?? in
  the spirit of Krugman we study the dynamics of
  nominal adjustment when
• the fiscal stance deteriorates exogenously
• but also when
• an external nominal shock (deflation abroad)
  implies an endogenous deterioration of the fiscal
  stance.

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On the endogenous deterioration of fiscal stance

• .

Suppose foreign prices fall from P? to P?
where ? is the financial gap of the government in
present discounted value. Note that ? become
positive per effect of the fall in external
prices. A Ricardian fiscal policy would then
require an adjustment in taxes and/or spending.
If this adjustment fails to materialize, the
effect of foreign deflation is the same as that
of a fall in taxes.
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Monetary policy

• As long as the exchange rate is fixed, the
  interest rate is determined by the uncovered
  interest parity.
• When the exchange rate target is abandoned, we
  posit that the domestic nominal interest rate is
  a linear function of the current depreciation
  rate (the interest rate responds weakly to it)

• This implies the case in which the government
  chooses a constant, post devaluation rate i(p).

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Results Original sin and the severity of crises

• Devaluation and inflation are increasing in the
  size of the imbalance ?, and the fraction of debt
  denominated in dollars --- decreasing in the
  long-run inflation rate.

They are increasing in the time span between the
emergence of an imbalance and price adjustment
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Non-linear response of prices to shocks
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more on the non-linear response
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Long-term debt and the option to delay price and
exchange rate adjustment...

• The government may not be able to delay
  adjustment past period t. Without seigniorage,
  for a delay to be consistent with equilibrium,
  the government budget constraint must hold
  exclusively by virtue of a wealth transfer from
  holders of long-term debt due to an unanticipated
  jump in its price ?.
• This is only possible if there is enough
  long-term debt outstanding at the time of the
  fiscal shock
• ?lt(1/r)/(L/?? P)
• The RHS is the maximum wealth transfer through an
  initial jump in the long-term bond price. If the
  above expression does not hold, the government
  has no choice but to abandon the fixed exchange
  rate at t.

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Long-term debt and an upper bound to the time of
adjustment

• A delay in the adjustment is only feasible, when
  the maximum fiscal transfer from bond-holders is
  below the size of the fiscal imbalance

• For any given stock of long-term debt, there is
  an upper bound to the timing of a crisis

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What pins down the timing of a currency collapse?

• Note that, while the fiscal imbalance makes
  devaluation inevitable, it fails to pin down the
  exact date of the collapse it pins down a time
  interval.
• This is a key difference relative to the
  first-generation literature. If we define the
  shadow exchange rate' it would not be true
  that a crisis must occur in the first period in
  which the shadow rate'' is above the current
  parity.
• Role for political-economy considerations,
  self-fulfilling run, constraints on monetary
  policy (as in the Krugman model).

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Short-term adjustment via nontraded good inflation

• Without long-term debt, a fiscal imbalance
  requires an increase in the current price level.
  But then...
• Holding the exchange rate fixed, an increase in
  the price of the nontraded goods could deliver
  enough adjustment in the short run causing real
  appreciation and current account deficit.
• The exchange rate adjustment would then be
  delayed, and coincide with real depreciation and
  current account surplus.
• Can this be an equilibrium outcome of the model?

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Confirming the role of long-term debt in delaying
adjustment

• A negative result in the standard version of
  open-economy models, without long-term debt there
  is no equilibrium with short-run nontraded good
  inflation, real appreciation and a CA deficit.
• In fact, with a delayed exchange rate adjustment
  anticipated depreciation implies a rising path of
  consumption, while external balance a declining
  path, generating a contradiction. Same as the
  price-consumption puzzle of currency pegs.
• This result confirms the key role of long-term
  debt in delayed adjustment to fiscal shocks.

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Macroeconomic dynamics

• However, a simple modification of our model
  brings theory more close into line with the
  stylized facts.
• Posit public goods affect marginal utility of
  consumption fiscal adjustment during currency
  crises implies a cut on public spending.
• Next, we show numerical results for the case of
  10 percent foreign deflation focusing on a
  two-period adjustment (0,1). We allow for two
  degrees of openness (10 and 50).

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Lessons from the model

• Exclusively per effect of fiscal imbalances
  (independent of competitiveness problems) the
  economy experiences
• NT good inflation, real appreciation, current
  account deficit in period 0.
• Exchange rate crisis, NT good deflation, real
  depreciation and a current account surplus in
  period 1.
• A relatively closed economy is not INSULATED from
  external nominal shock. Actually, devaluation
  rate and inflation is larger in the relatively
  more closed economy.

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Conclusions

• We have shown that the original sin
• Has important consequences for fiscal
  flexibility foreign currency borrowing and short
  term borrowing erodes the basis of an important
  automatic mechanism of adjustment to shocks.
• Our analysis suggest that the this mechanism may
  be an important factor causing the original sin
  the government has a strong temptation to let
  inflation drift, engineering large saving. We
  leave to future research a model where the
  original sin is an equilibrium outcome.