According to an IMF survey from Tuesday,
Europe's emerging markets are increasingly exposed to currency risk, heightening these countries' exposure to the banking crisis that is currently sweeping across Europe, and raising the alarm among those concerned with financial stability.
New research by the IMF shows that 15 percent of outstanding private sector credit in Eastern Europe today is either denominated in or indexed to foreign currencies, compared with only 4 percent a decade ago. Euroization (taking out loans in euros rather than the local currency) has also accelerated, adding to the risks.
GRAPH: The IMF attributes the strong growth of forex loans to a number of factors. The strongest incentive to borrow in other currencies was certainly the differential in interest rates and a growing willingness of people in EU member states to transact their real estate dealings in Euros.The IMF has defined four main factors that drove forex lending.
- The difference in interest rates between domestic and euro zone interest rates drives foreign currency borrowing, as suggested by economic theory. But unlike other parts of the world (for instance, Latin America), past exchange rate volatility has no statistically significant effect. One reason may be that EU membership increases people's willingness to assume currency risk. If anything, people expect their currencies to further appreciate as their countries converge towards Western European price and income levels.
- The banking sector's dependence on foreign capital, as measured by the loan-to-deposit ratio, is a strong contributor to foreign currency borrowing. Banks refinance themselves abroad and then pass on the currency risk to their clients, if only because they often are not allowed to hold open currency positions.
- Openness, captured by the relative size of foreign trade, matters also. Revenues from abroad make it easier for companies to hedge their foreign currency exposure. However ,this does not seem to be the case for households—remittance flows do not seem to increase foreign currency borrowing.
- Regulatory policies (for instance, higher risk weights for foreign currency loans) have some measurable effect, but it is pretty weak. The impact of such policies disappears entirely if direct borrowing from abroad is included.
In sum, foreign currency borrowing is a by-product of EU membership. First, by fully liberalizing the capital account, the EU offers borrowers increased access to foreign funding, both through domestic banks affiliated with foreign parents and directly from abroad.Hungary and the Ukraine have already tapped the IMF for fresh funds. Hungary today finalized a €20 billion loan package coming from the IMF, the EU and the World Bank. Ukraine has already negotiated an IMF loan package worth $16.5 billion. Others will be banging the door of the IMF soon, it can be predicted safely.
Second, by increasing trade openness, the EU provides hedging opportunities, especially for the corporate sector. Finally, EU membership seems to boost the private sector's confidence in exchange rate stability and imminent euro adoption, making devaluation seem like a low probability.