A policy usually followed by many banks, especially those in countries belonging to the emerging or developing group, is lending on a foreign currency. This practice has been extremely popular during the 2000's, where in Europe developing countries witnessed foreign currency loans in excess of 50% of total loans (see graph below). The practice does not just take place in developing countries; borrowers in countries with a relatively stable currency or one which is appreciating pursue such strategies in order to minimize the amount of funds they have to return in terms of local currency.
|Source: Foreign Currency Loans and Systemic Risk in Europe|
Interestingly, most Central Banks appear to be approving of such behaviour since foreign currency loans are usually a strong growth driver. According to a recent paper, Turkey witnessed a significant increase in growth since forex loans expanded, although restrictions (which were later eased) on household loans were imposed in 2009. Economic theory, and more specifically the currency substitution view, states that high inflation drives high forex lending as people mistrust their domestic currency. Conversely, as inflation falls and domestic currency appreciates, demand for loans is reduced (see graph below). The rationale behind this idea is simple: if domestic currency rises, then I have to pay less in terms of domestic currency than I have borrowed. If, for example, I got a $1 million loan and the rate with my domestic currency currency was 2 units I would get 2 million units of domestic currency. If domestic currency rose to 1.5 unit per $1, then I would have to repay just 1.5 million units of domestic currency. The more stable the currency is, the less the probability that an appreciation will cause the value of the loan to fall, thus the incentive for foreign borrowing is reduced. In addition, this type of strategy works well for both the lender and the borrower.
A more interesting question is why high inflation leads to higher foreign currency borrowing. The reason is that as people see the value of their currency reduced by tremendous inflationary pressures, they tend to switch to something more stable, in most cases the US dollar. This was something evident in other cases of hyperinflations where the domestic currency was discarded by the residents and something else was used in transactions. Yet, what the theory cannot explain is why people choose to borrow in foreign currency when borrowing in domestic currency is something they could have done to reduce the value of their loans. The only possible explanation from my point of view is that when people see a very high rate of inflation (although not as high as to discard the currency) , they expect it will fall sooner or later so they decide to gamble with foreign currencies to win the difference. Such a practice would have been extremely successful had it been followed in Turkey since the late 1990's or early 2000.
What one should note here is the dangers such practices pose for the banks themselves: if the currency depreciates significantly, they are in grave danger of never seeing their loans repaid. Thus, it is essential for the banks to hedge their foreign currency loans if they wish to minimize the exchange rate risk; risk arises from the banks' unwillingness to do so. In the Fed article cited above, Yesin calculates something very interesting: the foreign currency mismatch index, which is a measure of net unhedged foreign liabilities (foreign liabilities minus foreign assets minus loans in foreign currency) over total assets. This indicates the indirect exchange rate risk that banks assume when they lend to unhedged borrowers as derived from the probability of a joint failure of households and nonfinancial corporations to service their foreign currency loans as a result of a foreign currency appreciation (or domestic currency depreciation). The results presented are quite interesting:
As we can see, most of the non-EZ countries have a significant exposure to foreign exchange risk. Interestingly, if these countries face a currency depreciation, and bank need to be bailed out, the excess funds needed to bail the country out will further depreciate the currency; this will mean that the cost of repaying the funds will be further increased, thus promoting more failures and bad debts. Nevertheless, given that most of these countries are not yet caught up in the recessionary spiral the whole of the EZ has been in (with the exception of Croatia which is the only case which needs to be further examined), the probability of such a thing occurring is low.
Slovenia on the other hand is a very different story. With recent developments stating that Slovenia is one of the most likely candidate for the next EU bail-out, given the similarities the country poses with Cyprus, and the fact that it has been in recession for at least the last year, it is interesting to note that a depreciation of the euro could deeply impact the country and have severe consequences for the country's already wounded banks. The problem with Slovenia lies not just with the euro depreciating but with other currencies appreciating as well. Slovenia's bank have given out many loans in Swiss Francs over the past 5 years; if the CHF appreciates more than the euro does then consequences could be devastating for households and corporations which borrowed in the currency. While 4% of total assets may not appear to be much, for banks which are heavily depended on regulatory requirements to lend even a change of 1% could wreck havoc; especially if we are talking about a bank with very low capital requirements.
It is not that banks can be destroyed with a 1% loss. It is that banks with trust issues cannot sustain the consequences of such actions: people lose confidence in the banks, they withdraw money thus reducing liquidity; their fear causes consumption to fall, which means that investment also falls. These, in addition to higher unemployment, make non-performing loans increase, which brings banks a step closer to collapsing.
Is this as bad as it sounds? Unfortunately, I cannot predict the future paths of neither the CHF nor the Euro. The Euro has been appreciating with regards to the CHF over the past year, yet, given the instability of the region, large movements in both currencies cannot be discarded. This puts Slovenia's banks at the mercy of both currency speculators and the ECB; unfortunately for the country they cannot distinguish which represents the lesser evil. As Slovenia sees its growth potential reduced it would be a good time to impose restrictions on the banks' lending on foreign currency, either by forcing hedging or by restricting further lending in other currencies in general.
Skeptics might say that it would put too much emphasis on the euro and the success of the Eurozone. This might be true, but whether we like it or not this is our domestic currency and it is probably the best hedge ailing banks like the ones in Slovenia can do at the moment.