Should Governments Regulate Away FX lending?

By: Jeromin Zettelmeyer Director for Policy Studies

By Jeromin Zettelmeyer and Piroska M. Nagy

“Financial dollarisation” – domestic borrowing and lending in foreign currency (FX), even when the borrower’s income is in domestic currency – is back on the policy agenda. Unlike the 1990s, the victims of financial dollarisation are not longer mainly in Asia – which suffered particularly in its 1997-98 crisis – or even in Latin America.  Instead, “currency mismatches” (another expression for unhedged borrowing in FX) struck most harshly in emerging Europe. They aggravated the 2008-09 crisis in countries with large currency depreciations (Ukraine), complicated the crisis response and monetary policy effectiveness in many countries with significant FX exposures, and induced highly contractionary macroeconomic policies in countries that defended their pegs (Latvia).

As a result, the question of how these economies can “de-dollarise” (or in some countries, “de-euroise”) is receiving much policy attention: particularly, in the form of tougher regulation and even bans on foreign exchange borrowing. For example, in December 2009, Hungary adopted new regulations that require higher household debt servicing capacity and lower loan-to-value ratios for consumer and mortgage borrowing denominated in foreign exchange. In June 2010 the new Hungarian government went further: it announced a ban on the registration of FX-denominated mortgage loans. Some other transition countries also are moving in the same direction in the area of regulation.                                                                                                                                         

But is tough regulation necessarily the right answer? In a recently published EBRD Working paper, we argue that if emerging European policy makers want to get the policy response right, they would do well to look at the international experience on dollarisation, reflected in a large literature on the subject, which was written largely in the decade between the 1997-98 Asian and the 2008-09 European crisis. This literature, combined with our own evidence on emerging Europe and Central Asia, leads to three main conclusions.

First, financial dollarisation is primarily, if not exclusively, a macroeconomic phenomenon. This is most obvious today in the less developed countries of Eastern Europe and Central Asia, which suffer from high inflation volatility. In such countries, writing long-term financial contracts using local currency units simply does not make sense, because the future real value of interest and principal payments in local currency is very uncertain. As a result, long term FX borrowing may actually be safer than local currency borrowing over the same maturity – even if it exposes borrowers to the threat of insolvency in the (comparatively rare) event of a large depreciation.

What about the highly “euroised” countries further west, where inflation had been much lower and quite stable since the late 1990s? Here, the link between macroeconomic policies and FX borrowing was more subtle. Notwithstanding low inflation, local currency lending rates in these countries tended to be much higher than FX lending rates. In part, this reflected a lack of monetary policy credibility: while inflation was relatively low, and currencies were generally expected to appreciate, this could not be taken for granted. At the same time, pegged or heavily managed exchange rates gave FX borrowers a false sense of security, particularly in EU countries, which viewed themselves on a straight path to euro adoption. In such countries, the temptation to borrow much more cheaply in FX was simply overwhelming.

Second, while weak macroeconomic policies and institutions were an important factor in fostering dollarisation in emerging Europe, they were not the only factor. It would otherwise be impossible to explain why, for example, FX lending as a share of total bank lending doubled in Hungary between 2004 and 2008 (see chart), a period in which macroeconomic policies (particularly monetary policy, but after 2006 also fiscal policy) generally improved. The driving factor here (and in other of more financially integrated emerging European economies in the Baltic region, and in south-eastern Europe) was a foreign-financed credit boom (for a comprehensive documentation, see a recent IMF working paper). In their rush to expand credit, banks relied largely on cheap FX funding either from parent banks, or borrowed in international capital markets, rather than by building their local deposit base. To avoid currency mismatches on their own balance sheets, the preferred lending currency was also foreign. Hence, rising euroisation was a by-product of the 2004-2008 lending boom, which turned out more extreme in emerging Europe than in any other region of the world.  

Third, domestic capital market development is a critical component of de-dollarisation policy, particularly in countries that already have reasonable macro stability. From what has been said so far, this is not entirely obvious: a country with credibly low and stable inflation, a floating exchange, and macro prudential tools that dampen credit booms and discourage their financing in FX should not have a dollarisation problem, regardless of whether it has well-functioning capital market. However, capital market development is nonetheless important, for two reasons. For one, longer-dated bonds are a bellwether of macro credibility. Their yield is reflection of faith in the governments’ ability to keep inflation low and stable, and an incentive to maintain stabilisation on track. Most importantly, domestic capital markets help overcome the shortage of domestic currency long term funding that biased emerging Europe’s lending booms in the direction of FX. Banks that wish to expand their lending are less likely to resort to FX funding if there is a domestic investor base – for example, pension funds and insurances – that is interested in longer dated debt instruments,  and if there is a market that makes these instruments liquid and easy to price.

With this in mind, is the current focus on regulatory responses to financial dollarisation a good idea or not? The answer depends in part on the country. In countries in which inflation volatility continues to be a problem, making FX lending illegal (or prohibitively expensive) is downright counterproductive: it may destroy longer term lending altogether. However, more subtle forms of regulation can play a useful role, particularly in more advanced countries, and particularly when they complement good macro policies, and are embedded in a more general set of macro prudential instruments. For example, these could include risk weights and reserve requirements on banks that are higher for FX loans and FX funding, respectively; and setting maximum payment-to-income and loan-to-value ratios that guard against household overborrowing, particularly in FX. While regulation need to be country-specific, its coordination is essential in order to limit regulatory arbitrage. Such coordination is taking place, for example, under the European Bank Coordination (“Vienna”) Initiative.

In sum, our analysis suggests that the fight against emerging Europe’s addiction to FX needs to be country-specific and multipronged. Regulation may be justified, particularly in the more financially integrated countries. But it should never carry the sole burden of the fight against addiction to FX. Depending on the country, the main focus of de-dollarisation could be to stabilise and reform macroeconomic institutions; or it could be a combination of regulation, macroeconomic credibility-building, building the legal and institutional underpinnings of local currency money and bond markets, and developing the demand side of these markets and making them more liquid.

In recognition of these links and complementarities, the EBRD has recently launched a new Local Currency and Local Capital Market Development Initiative. In the next 12 months, at the request of country authorities, the EBRD will conduct country-by-country diagnoses of the causes of financial dollarisation in many of its countries of operation, jointly with other IFIs such as the IMF and the World Bank, as well as private sector associations. All key factors will be considered: macroeconomic volatility and credibility; FX regulatory conditions; local currency market development; and associated legal, regulatory, and infrastructural requirements. Based on these diagnoses, the EBRD will support the development of local capital markets by using the lending and funding instruments at its disposal, in coordination with other investing IFIs; and through technical cooperation.

The crisis has put financial dollarisation at the centre of attention in emerging Europe. That is a good thing. Ten years ago, emerging Asia and Latin America were in a similar situation. By and large, they drew the right consequences, and today, financial dollarisation is no longer the first-order problem in these regions that it once was. There is no reason why emerging European countries should not follow their example. The political will to do something about the problem is there, and macroeconomic conditions are favourable. But in order to make the most of their historic opportunity, they will need to be patient, avoid quick fixes and focus on the hard work of improving macroeconomic policies and institutions and developing local capital markets.

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