Original Sin and Deviations from Covered Interest Parity

Abstract

Foreign holdings of sovereign debt in emerging markets (EMs) shift from foreign currency (FC) to local currency (LC), especially after the global financial crisis. We show that such a dissipation of original sin enlarges deviations from covered interest rate parity (CIP) in EMs, as FC debt is more important in transmitting global financial cycles to EMs than LC debt. We further provide evidence that FC debt is more efficient in tapering CIP deviations because it bypasses capital controls, circumvents high inflation, weak institution and asymmetric information, and enhances price discovery.