Currency Mismatch

Currency mismatch is a situation in which a borrower's assets or income are in one currency while its debts are in another, so that a change in the exchange rate changes the real burden of the debt. A company that earns local currency but owes US dollars, a bank that funds local-currency loans with foreign-currency deposits, and a government that borrows abroad in a currency it cannot print all carry a mismatch. The risk is greatest when the debt is large and the currency can fall sharply.

It differs from the everyday foreign exchange risk on a single invoice because it sits on the balance sheet and can threaten solvency, not just profits. A related problem is maturity mismatch, where short-term funding pays for long-term assets; the two often appear together and compound each other in a crisis. In 1999 economists Barry Eichengreen and Ricardo Hausmann coined the term "original sin" for many countries' inability to borrow abroad in their own currency, which forces mismatches on them.

Imagine a farmer who is paid in apples but borrows a sack of oranges from a neighbour, promising to repay in oranges next year. If a poor orange harvest makes oranges twice as dear in apples, the farmer must hand over far more apples to buy back the same sack. Nothing about the farm has changed, yet the debt has doubled in the only thing the farmer earns.

Firms, banks and countries face the same trap when they earn one currency and owe another. When their own currency loses value, every foreign-currency loan grows in local terms overnight. Many borrowers who looked healthy before a devaluation can be pushed into default by the exchange rate alone.

Eichengreen and Hausmann set out the idea in a paper for the Federal Reserve Bank of Kansas City's 1999 Jackson Hole symposium. They argued that many emerging economies cannot issue long-term debt abroad in their own currency, however sound their policies, so foreign borrowing ends up in a reserve currency such as the US dollar. Later work with Ugo Panizza focused on the international side of the problem.

Other causes are domestic. In economies with high dollarization, savers keep deposits in dollars, so banks lend in dollars to firms whose income is local. Foreign-currency loans often carry lower interest rates, tempting borrowers into a version of the carry trade. Morris Goldstein and Philip Turner, in a 2004 book on controlling currency mismatches in emerging markets, argued that policy choices also matter and that mismatches can be reduced.

The basic measure is the net foreign-currency position: foreign-currency assets minus foreign-currency liabilities, including any hedging contracts. The change in a borrower's net worth from a currency move is approximately:

• $\Delta W$ is the change in net worth, in local currency.
• $A_{FX}$ is foreign-currency assets, in foreign currency.
• $L_{FX}$ is foreign-currency liabilities, in foreign currency.
• $\Delta E$ is the change in the exchange rate, in local currency per unit of foreign currency.

Take a firm with USD 2 million of dollar assets and USD 10 million of dollar debt, a net position of minus USD 8 million. If the local currency weakens from 30 to 36 per dollar, then $\Delta W = (2 - 10) \times 6 = -48$ million in local currency. A firm whose export earnings are in dollars has a natural hedge that offsets part of this, which is why exporters can carry dollar debt more safely than shops or utilities. Banking regulators limit banks' net open positions for the same reason.

• Asian financial crisis. When Thailand floated the Thai baht on 2 July 1997, firms and banks that had borrowed short-term in dollars faced debts that ballooned, and the crisis spread to Indonesia and South Korea.
• Argentina. The peso had been fixed one-to-one with the dollar under the 1991 Convertibility Law. Its collapse in early 2002 left dollar debts far beyond local earnings, and the Argentine peso lost most of its value.
• Swiss franc mortgages. Households in Poland, Hungary and elsewhere in central and eastern Europe took out mortgages in Swiss francs. When the Swiss National Bank removed its cap on the franc against the euro on 15 January 2015, repayments jumped; Hungary had already begun converting such loans into forints in 2014–15.
• Turkey. The sharp fall of the Turkish lira in 2018 strained companies with large foreign-currency borrowing.

Countries reduce mismatches by building local-currency bond markets, holding foreign exchange reserves as a buffer, limiting foreign-currency lending to unhedged borrowers through macroprudential policy, and, since the IMF's 2022 review of its Institutional View, using pre-emptive capital flow management measures against build-ups of foreign-currency debt. Mismatches also affect exchange rate policy: central banks may resist depreciation for fear of the balance-sheet damage, which limits their monetary policy independence even under a floating rate.

• Bank for International Settlements
• International Monetary Fund: The Institutional View on Liberalization and Management of Capital Flows