Mr [Barry] Eichengreen spells out…an ingenious plan…he proposes the creation of a market for lending and borrowing in a synthetic unit of account, a weighted basket of emerging-market currencies. Such bonds would be popular with investors, since the currency would be more stable than the sum of its parts and, at first at least, carry attractive yields. Importantly, such a market, if it could be established, would eventually let emerging-market economies tap foreign capital without currency mismatches. This is because those, such as the World Bank, that issued such bonds would be keen to reduce their exposure to the basket by lending to the countries in that basket in their own currencies.
The idea is to prevent a mismatch between assets and liabilities:
…some countries’ financial fragility results simply from their need for foreign investment. In the most susceptible countries, firms and banks borrow heavily in dollars, while lending in local currencies. If the value of the local currency wobbles, this mismatch between domestic assets and foreign liabilities is cruelly exposed.
Why are the assets and liabilities of emerging markets so ill matched?…International investors are very choosy about currencies. Most consider only bonds denominated in dollars, yen, euros, pounds or Swiss francs. This select club of international currencies is locked in for deep historical and structural reasons. Thus, poor countries that want to borrow abroad must bear currency mismatches through no fault of their own.
I have no problem with trying the idea, but what can we expect?
First, it remains a puzzle why lenders are reluctant to denominate international loans in anything but the five major currencies (dollar, Euro, yen, sterling, and Swiss franc). So it is hard to know whether another unit of account could join this exclusive club. Perhaps investors would find the basket hard to evaluate or simply unwieldy. They might not want the basket any more than they would lend in Brazilian real, which is the original source of the problem.
Second, say that the basket did become widely used and relatively stable. Underdeveloped countries would then have their liabilities in a stable unit of account but their assets would still fluctuate in value. We would return to a version of the original problem. Now one might hope that the basket-denominated debts would be swapped back into the local currency. But I don’t see any particular reason why such swaps would increase in ease.
Third, if the basket becomes more liquid than its underlying components, the system may be vulnerable to arbitrage and speculation opportunities. Whether these would be stabilizing remains an open question. In essence the price of the basket would tell you where the underlying components are headed. We would have a new version of the “stale pricing” problem.
The Eichengreen proposal represents an old dream, and one that I have been taken with myself: improve risk-sharing simply by creating a new nominal value. This may sound like economic alchemy, but hey, it worked with stock index futures. That being said, in this arena the number of failures far outweighs the number of successes.
Thanks to Chris Danford for the pointer.