Foreign Currency Debt

Foreign currency debt is borrowing that must be repaid in a currency other than the one the borrower earns or reports in. A Turkish company with dollar bonds and a Polish household with a Swiss franc mortgage both hold it. Borrowers take it on because foreign lenders may offer larger amounts, longer terms or lower rates than are available at home.

The defining risk is the exchange rate. If the borrower's currency weakens, the debt grows when measured in the money the borrower actually has, even though nothing about the loan has changed. This gap between what is owed and what is earned is called a currency mismatch. The label depends on the borrower: the same dollar debt is domestic for an American and foreign for an Indonesian.

Imagine borrowing a neighbour's bag of apples and promising to return the same bag of apples next year, while you grow only oranges. If apples become scarce and expensive, you will need to sell far more oranges to buy back the apples you owe. The loan did not change; the price of what you owe did.

That is the position of a borrower with a loan in another currency. When the home currency is stable, the loan can look cheap and convenient. When the home currency falls, every repayment takes a bigger bite out of income. Because many borrowers in the same country tend to be hit at the same moment, the trouble can spread from one household or company to the banks that lent to them and, in the end, to the government that has to clean up.

The size of the debt in the borrower's own currency is the foreign amount multiplied by the exchange rate:

• $D_{\text{local}}$ is the value of the debt in the borrower's home currency.
• $D_{\text{foreign}}$ is the amount owed in the foreign currency.
• $E$ is the exchange rate, in units of home currency per unit of foreign currency.

For example, a company owes USD 50 million when the exchange rate is 20 units of its home currency per dollar, so the debt is worth 1,000 million in local terms. If the home currency falls to 30 per dollar, the same debt is worth $50 \times 30 = 1{,}500$ million, an increase of 50%, while the company's local revenue may not have grown at all. Interest payments rise by the same proportion.

In a paper prepared for the Federal Reserve Bank of Kansas City's Jackson Hole symposium in August 1999, economists Barry Eichengreen and Ricardo Hausmann used the term "original sin" for the inability of many countries to borrow abroad in their own currency, or to borrow long term even at home. Later work with Ugo Panizza argued that this was less about bad policy in individual countries and more about the structure of global capital markets, which favour a handful of major currencies.

Many emerging-market governments have since reduced the problem by issuing more bonds in local currency. Much of the exposure has shifted to companies, which borrow in dollars through international bond markets and banks, often attracted by the interest rate differential between dollar and local rates. Economies with widespread dollarization of bank deposits and loans face a related form of the same risk.

• Asian financial crisis, 1997–98. After Thailand floated the baht in July 1997, banks and companies across the region that had borrowed short-term in dollars faced sharply higher debts as their currencies fell.
• Argentina, 2001–02. The end of the peso's one-to-one link with the dollar in early 2002 left borrowers and the state with dollar obligations they could not meet, and the government entered sovereign default. The later history of the Argentine peso kept the issue alive.
• Swiss franc mortgages, 2015. When the Swiss National Bank dropped its minimum exchange rate against the euro on 15 January 2015, the franc jumped and households in Poland, Croatia and elsewhere with franc-denominated mortgages saw their debts rise. Hungary had converted most such loans into forint shortly before.
• Turkey, 2018. A steep fall in the Turkish lira raised the cost of the large foreign currency borrowings of Turkish companies.

In each case a weaker currency raised debt burdens, which caused defaults and capital flight, which weakened the currency further. This feedback loop is a common route into a currency crisis.

Borrowers can reduce exposure through hedging with forwards, swaps or options, though hedges cost money and may be unavailable for long terms. Exporters with foreign currency revenue have a natural hedge, because their income rises with the debt when the home currency falls. Where a currency cannot be delivered offshore, investors often use a non-deliverable forward instead.

Governments and regulators use other tools. Many central banks limit foreign currency lending to unhedged households, set capital or liquidity rules for banks' currency positions, and hold reserves to supply foreign currency in a stress. The International Monetary Fund monitors external debt in its country reviews and can lend to countries that lose access to markets, while the availability of dollar liquidity worldwide largely decides how painful a refinancing squeeze becomes.

• Bank for International Settlements: Global liquidity indicators
• International Monetary Fund: Global Financial Stability Report