Foreign Currency Denominated Borrowing in
Central Europe: Trends, Factors and
Consequences
By László Bokor Gábor Pellényi
February, 2005.
Foreign Currency Denominated Borrowing in Central-Eastern-Europe
ICEG EC Opinion Nr 5.
INTRODUCTION
Foreign currency borrowing has been a relatively new but fast spreading phenomenon in the
Central European New Member States. Foreign currency borrowing has been driven by various factors including interest rates gaps between domestic and foreign currencies, appreciation of local currencies, weakening of liquidity constraint of consumers. While the stocks are still low, the flow figures reflect a sizeable shift in the borrowing pattern of both household and corporate sector and prompted several institutions and economists to warn concerning the likely undesired consequences of this trend.
The paper presents the evidence concerning the different growth of foreign currency denominated borrowing in the Czech Republic, Hungary, Poland and Slovakia. Te first part gives a brief overview about the risks involved with foreign currency borrowing. The second part presents the empirical evidence and the driving factors behind them in the four New
Member States.
I. RISKS IN FOREIGN CURRENCY BORROWING
Foreign currency loans may offer low interest rates in nominal terms, but the risks involved are substantial. Foreign currency borrowers are exposed to significant exchange rate and interest rate risk, and maturity mismatches may arise. The notion that these risks are covered by interest savings is applicable only to the aggregate number of borrowers but not to individual borrowers, who (can) usually opt for only one borrowing currency. In light of the large share of foreign currency loans in total lending in certain regions and of the particularly high homogeneity of collateral provided by households, substantial concentration risks may emerge. If the explanation patterns offered by the theory of rational herd behavior for the boom in foreign currency borrowing are correct, it may be possible that borrowers who took out Swiss franc‐denominated loans did not consider all the risks involved in their decisions. Therefore, the trends in foreign currency borrowing deserve to be closely monitored.
I.1 Exchange Rate Risk
Foreign currency borrowers are directly exposed to foreign exchange risk. Valuation changes triggered by shifts in exchange rate relationships increase or decrease the domestic currency denominated value of the foreign currency liabilities. Therefore, interest to be paid on the foreign currency loans outstanding also changes. Exchange rate movements feed through to interest expenses in every interest payment period, while (in bullet loans) the amount of capital outstanding is affected only by unrealized valuation changes until the end of maturity.
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Foreign Currency Denominated Borrowing in Central-Eastern-Europe
ICEG EC Opinion Nr 5.
Given the volatility of exchange rates, the actual amount of exchange gains or losses depends critically on the length of the period under review. It must be noted, however, that for bullet loans, the exchange rate gains (or losses) posted in the past few years were merely unrealized gains and that gains from favorable exchange rate movements materialized solely in interest payments. Also, lending in foreign currency increased the volatility of the amount of loans outstanding. It must also be noted that over a prolonged period of time, exchange rates can move into completely different directions. The exchange rate movements of different borrowing currencies may differ on a large scale.
I.2 Interest Rate Risk
Foreign currency loans are exposed not only to exchange rate risk, but, since they are usually
