Old sins. Exchange Clauses and European Foreign Lending in the 19th Century

This paper challenges a popular explanation for ‘original sin’ – the default prone borrowing of long term debt in foreign exchange by emerging markets – that emphasizes the lack of credibility and commitment of governments, that prevents them from borrowing in their own currency. Basing our account on the history of emerging market borrowing in the nineteenth century, we offer an explanation based on historical path dependence. We document that almost all IPO’s of governments in foreign markets were in foreign exchange, or with foreign exchange clauses, independent of those countries’ institutional features. We show that a small number of countries could circulate debt denominated in their own currency in secondary markets, again irrespective of their constitutional setup. We argue that market liquidity can explain both phenomenon. Having an internationally circulating currency allows countries to circulate their debt in secondary markets. Going for an IPO in a large financial center, is an attempt to tap the greater liquidity of that center’s money market and currency. It makes prefect sense to borrow then, in that center’s currency. The evolution of vehicle currencies and liquid money markets has more to do with historical evolution of trade, going back to medieval times, rather than with institutional reform. Escaping from original sin requires that the country emerge as a leading economic power – a rare historical event, reserved for the U.S of the nineteenth century and Japan of the twentieth century.