Can Indexed Debt Absolve Original Sin? The Role of Inflation-indexed Debt in Developing Local Currency Markets

Abstract

The Latin American region can be characterized as one with significant levels of financial dollarization. The region’s inflation experience, with periods of high and volatile inflation, is likely to have been a key contributing factor. Over the last ten years, the average inflation rate in the region has been about 13 per cent, while the volatility of inflation has been about 15 per cent.2 This eroded confidence in the real value of domestic currency-denominated assets and generated demand for dollar-denominated financial assets. As a result, public debt portfolios now generally carry excessive currency risk given likely future revenue streams. This raises exposure to exchange rate risk, increasing countries’ vulnerability to external shocks, changes in investor sentiment and self-fulfilling runs, and exacerbating the fall-out from policy errors.3 The situation is further exacerbated by the high foreign currency exposure of the banking sector, which could represent a substantial contingent liability on the public sector’s balance sheet. As a consequence, countries are more prone to liquidity and solvency crises.KeywordsMonetary PolicyRisk PremiumPublic DebtSecondary MarketDebt ManagementThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.