Consumption baskets and currency choice in international borrowing

• We study the determinants of external borrowing in local currency in emerging market economies.
• Heterogeneity in consumption baskets and nominal rigidities determine the currency composition of external liabilities.
• With flexible prices, foreigners demand a lower risk premium on local currency bond.
• Nominal rigidities reduce the risk premium demanded by local lenders, and thus help explain external liability dollarization.

We propose a novel explanation for the empirically low prevalence of external borrowing in local currency in emerging market economies, a phenomenon sometimes referred to as the original sin of international finance. We study the endogenous currency denomination of an emerging economy's assets and liabilities within the context of a dynamic stochastic general equilibrium (DSGE) model with portfolio choice featuring non-tradable goods and nominal rigidities. We find that these features lower the correlation between the local currency and domestic lenders' consumption. They thus reduce the risk premium demanded by domestic lenders on local currency debt, and can therefore help explain the low willingness of foreigners to lend in local currency.