Up from sin : a portfolio approach to financial salvation

Abstract

In this paper, we develop a proposal with the potential to greatly improve the ability of developing countries to reduce their exposure to other countries´ interest rate and exchange rate volatility and to lower their cost of raising capital abroad. The key to achieving these goals is for developing countries to borrow in their own currencies and for investors to lend by creating portfolios of local-currency government debt securities that employ the risk management technique of diversification to generate a return-to-risk that competes favourably with other major capital market security indices. We show, based on data from the early 1990s, that a portfolio of emerging market local currency debt can generate rates of return relative to risk that compete with those of major securities indices in international capital markets. It bears noting that the early 1990s witnessed several severe shocks to international capital markets, including the crises in East Asia, the Russian Federation and Brazil, and the failure of Long-Term Capital Management. We also analyse the implications of deploying such a policy for attracting capital to developing countries, the impact on the stability of their financial systems and on their costs of borrowing, and the implications for future development of local capital markets.