Loans And Currency: What's The Connection?

Loans can be in foreign currency or local currency. Foreign currency loans can be cheaper than local currency loans, but they expose firms to exchange rate risk by creating a currency mismatch on their balance sheets. This can affect the ability to repay the debt. For example, during the 2008 financial crisis, many people in Hungary defaulted on their loans as the value of their currency lost a lot of value against other currencies, causing monthly repayments to skyrocket. On the other hand, firms are more likely to borrow in foreign currency if they have more income in that currency or if it is cheaper due to a UIP deviation.

Foreign currency loans and credit risk

Foreign currency loans can be cheaper than local currency loans, but they expose firms to exchange rate risk. This risk arises from a currency mismatch on their balance sheets, which can affect the ability to repay the debt. For instance, a 10% depreciation of the local currency quarter-to-quarter increases the probability of a firm becoming past due on its loans by 42 basis points for firms with foreign currency debt. This indicates that exchange rate risk can translate into credit risk for banks.

Firms that borrow in foreign currencies remain exposed to exchange rate risk, which can lead to significant economic implications. A depreciation in the local currency can increase the likelihood of a firm defaulting on its loans. Additionally, firms with foreign currency debt are more likely to be downgraded or assigned a higher probability of default by banks when the local currency depreciates.

The decision to borrow in foreign currency is influenced by the currency composition of a firm's income. Firms with a higher proportion of foreign income are more likely to borrow in foreign currency, especially if it is cheaper due to UIP deviations. However, firms that borrow in their local currency can avoid currency mismatches and protect themselves from financial risks and future financial shocks.

Local currency financing involves issuing long-term debt in the borrower's currency, allowing them to service their debts stably and avoid bankruptcy in the event of depreciation. It helps develop businesses, markets, and infrastructure without disruptions caused by currency fluctuations. Governments in emerging markets can also benefit from local currency financing by issuing government bonds in local currency, balancing obligations with local currency income.

Cross-currency swaps

In a cross-currency swap, the two parties can enjoy a combined gain from trade. The principal (of equal amount) is swapped at the beginning of the agreement, and interest payments are paid by the counterparty over the term. At maturity, both the principal and interest on the foreign currency are repaid by the counterparty, which ends the swap obligation. The after-swap cash flow is the same as if the parties could borrow at the domestic rate of the foreign currency. For example, Party A borrows at 9% C$ and swaps the debt with Party B, who borrows at 6% $. Each party saves 1% compared to if they had borrowed at their available foreign rate.

Swap banks can also be present in cross-currency swaps to help find a counterparty to fit a company's needs, facilitate the exchange of cash flows, and take on some risk. The fee they take for their services must be smaller than the quality spread differential; otherwise, there would be no incentive for the parties to enter the swap.

Borrowing in foreign currency from local banks

In developing countries, it has been a common practice for businesses to obtain loans from international markets that are issued in hard currencies such as the US dollar or Euro. This practice leaves borrowers vulnerable to foreign exchange (FX) risk. For instance, if their local currency depreciates, they may struggle to service their debts as the value of the loan increases relative to their currency. Providing loans in the borrower's local currency helps mitigate this risk and protects them from financial shocks.

Local currency financing is the practice of issuing long-term debt in the currency of the borrower's income. This approach helps businesses avoid currency mismatches and ensures stable debt servicing, reducing the risk of bankruptcy. It also enables governments and businesses to align their obligations with their local currency income, facilitating better financial planning and budgeting.

However, the decision to borrow in a foreign currency depends on various factors. Firstly, it is advisable only if the borrower has a certain income stream in that currency. Secondly, the stability of the local currency plays a role, with some households and businesses opting for loans in USD or CHF when their local currencies are considered less stable. Additionally, firms with a larger share of their sales in foreign currency are more likely to borrow in that currency.

While borrowing in foreign currency from local banks is possible in some countries, it may be restricted in others. For example, in the US, banks typically offer loans only in US dollars. On the other hand, Iceland has previously offered loans in various currencies, which created challenges during the 2008 financial crisis when the kroner weakened significantly. Overall, while foreign currency loans can provide benefits, they also introduce risks that borrowers should carefully consider before proceeding.

Exchange rate risk

There are three types of exchange rate risk: transaction exposure, translation exposure, and economic or operating exposure. Transaction exposure arises from the effect that exchange rate fluctuations have on a company's relative purchasing power. For example, a US furniture manufacturer that sells locally will still be impacted by imports from Asia and Europe, which may become cheaper and thus more competitive if the dollar strengthens. Translation exposure is faced by companies with subsidiaries operating in other countries. The subsidiary will do business in its home currency, but the numbers in its financial reports to the parent company will fluctuate with the currency value. Economic exposure is caused by the effect of unexpected currency fluctuations on a company's future cash flows and market value. It is challenging to hedge against economic exposure as it is difficult to quantify precisely.

There are several strategies that companies can employ to mitigate exchange rate risk. One way is to diversify their production facilities and markets for products. However, this may cause the company to forgo economies of scale. Having alternative sources for key inputs is also strategic in case exchange rate moves make inputs too expensive from one region. Companies can also diversify their financing by accessing capital markets in several major nations to raise capital in the market with the cheapest cost of funds. Matching currency inflows and outflows is another simple strategy. For example, if a US company has significant inflows in euros, it may consider borrowing in euros. Currency risk-sharing agreements are contractual arrangements where two parties involved in a sales or purchase contract agree to share the risk arising from exchange rate fluctuations. Back-to-back loans, or credit swaps, involve two companies in different countries borrowing each other's currency for a defined period. Currency swaps are similar but do not appear on the balance sheet.

Borrowing in local currency can help companies avoid exchange rate risk. Local currency financing is the practice of issuing long-term debt in the currency of the borrower's income, allowing them to service their debts stably and avoid bankruptcy in the event of depreciation. It helps businesses, especially in developing countries, avoid currency mismatches and protects them from financial shocks.

Foreign-currency lending

However, borrowing in foreign currency carries risks for the borrower. Exchange rate fluctuations can affect the borrower's ability to repay the debt. If the local currency depreciates, the debt service payments, when converted to the local currency, will increase, making it more difficult for the borrower to meet their obligations. This is especially true if the borrower's revenues are primarily in the local currency. As a result, firms may struggle to repay their debts and face higher probabilities of default.

Financial markets offer instruments to hedge against exchange rate risk, but these hedging strategies can be costly. Foreign currency loans can expose firms to a currency mismatch on their balance sheets, creating a potential risk for the firm's performance. This risk is known as the "balance sheet channel," which can counter or overturn the classic "expenditure-switching effect," where devaluations positively impact domestic firms' performance.

Despite the risks, foreign currency lending can be advantageous in certain scenarios. For companies with significant foreign sales or income, borrowing in the same currency can reduce the complexity of managing multiple credit lines and provide a natural hedge against exchange rate fluctuations. It also allows for a single source of funding, streamlining the financing process. Foreign currency loans can be particularly attractive when a UIP deviation makes them cheaper than local currency loans.

In conclusion, foreign-currency lending has become more prevalent due to increased global liquidity and policy factors. While it offers benefits such as natural hedging and streamlined funding, borrowers must carefully consider the risks associated with exchange rate fluctuations and their potential impact on debt repayment.

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