The period from 1870-1913 was a period of globalization in both goods and financial markets comparable to the present era of globalization. It was also a period rife with emerging market financial crises with great resonance for the experience that we have observed in the past decade. In both eras many emerging countries faced frequent currency crises, banking crises and twin crises. They also faced a number of debt crises coming on the heels of banking and currency trouble. In both periods many of these countries suffered from what Eichengreen and Hausmann (1999) refer to as original sin. The external debt that they accumulated to finance their development was almost strictly denominated in foreign currency or in terms of gold (or had gold clauses) before 1914, just as emerging market debt today is almost entirely denominated in dollars, euros or yen. When the exchange rate depreciates, debt service in gold or foreign currency becomes very difficult leading to an increased likelihood of default, the consequent drying up of external funding and economic collapse.
The emerging country experience stands in contrast to that of the advanced core countries which are financially mature, have credibility and either issue bonds denominated in terms of their own currency or manage their significant hard currency debt carefully. There were few crises in these countries. This leads us to wonder whether these debt structures might play a role in explaining the difference in crisis incidence. We also investigate whether balance sheet mismatches as discussed in Goldstein and Turner (2004) mattered. Finally we also examine whether poor reputation and accumulated default experience was a problem as hypothesized by Carmen Reinhart, Kenneth Rogoff and Miguel Savastano (2003) in their work on debt intolerance.
We have developed a database to allow us to identify and distinguish original sin and balance sheet crises from more traditional currency and banking crises for roughly 30 countries (both advanced and emerging) from 1880-1913 and over 40 countries between 1972 and 1997 the post-Bretton Woods period. We have data both on type of crisis incidence and on the fundamentals that economists believe are determinants of crises. A caveat worth keeping in mind is that the original sin data and our mismatch data especially in the recent period are highly incomplete and researchers still lack the coverage necessary to make definitive conclusions. Our data set then is somewhat unique in that the coverage and quality of the available data from 100 years ago are somewhat better than contemporary data. Nevertheless, we use the data of limited quality to estimate the probability of having a particular type of crisis using standard pooled probit models so as to show the correlation between original sin, mismatch and financial crises.
Our results do not find unambiguous support for the idea that hard currency debt is always associated with more financial turbulence. Good financial management of the original sin condition, strong financial development and agile responsiveness to crises seem to play a role in helping avoid crises. In fact, we find evidence that countries with significant or full-blown original sin can be divided into two subgroups. For example in the pre-1914 period, one group includes countries such as Argentina, Brazil, Chile, Italy and Portugal each of which suffered a financial catastrophe between 1880 and 1913. The other group, including Australia, Canada, New Zealand, Norway, and the US had relatively little trouble with financial crises in terms of frequency or virulence.
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The Role of Foreign Currency Debt in Financial Crises: 1880-1913 vs. 1972-1997
