Foreign Currency Loans

Foreign currency loans are loans that a bank makes in a currency other than the one used at home, such as a United States dollar (USD) loan made by a Pakistani bank or a Swiss franc mortgage made by a bank in Hungary. The borrower receives the foreign currency, or its local value, and must pay back the principal and interest in that same foreign currency. Firms that earn foreign currency from exports or that pay for imports use them most, but households in some countries have also taken them out, often because the foreign interest rate looked lower.

The product sits inside the wider subject of foreign currency debt, which covers bonds and cross-border borrowing by governments and companies. This entry is about the bank loan itself: how a domestic bank funds it, who should and should not borrow this way, and how central banks limit the risk. The central idea is the currency mismatch that arises when a borrower's income is in one currency and the debt is in another.

Imagine borrowing a bag of rice from a neighbour and promising to return a bag of rice, not money. If rice gets more expensive while you hold the loan, you have to work longer to buy the bag you owe, even though the size of the bag never changed. A foreign currency loan works the same way: the amount you owe is fixed in dollars, euros or francs, so a fall in your own currency makes every repayment cost more in the money you actually earn.

For an exporter who is paid in dollars, borrowing in dollars is like a rice farmer borrowing rice: what comes in matches what goes out, so the swings cancel. For a salaried worker paid in local money, the same loan is a bet on the exchange rate that the worker may not realise they are making.

A bank needs foreign currency before it can lend it. It usually gets it from foreign currency deposits held by its own customers, from borrowing in the interbank market, or from a currency swap with another bank. The loan is priced off a foreign benchmark such as SOFR for dollars plus a margin for the borrower's credit risk, rather than a domestic benchmark such as KIBOR.

The local cost of each payment depends on the exchange rate on the day it is made:

• $\text{Payment in foreign currency}$ is the instalment due, for example in dollars.
• $\text{Exchange rate}$ is the number of local currency units needed to buy one unit of the foreign currency.

Worked example: a borrower owes an instalment of 1,000 dollars. At 200 rupees per dollar it costs 200,000 rupees. If the rupee weakens to 250 per dollar, the same instalment costs $1{,}000 \times 250 = 250{,}000$ rupees, a 25% rise in the local cost with no change in the loan terms. A large currency devaluation can therefore turn a cheap-looking loan into an expensive one overnight.

The natural users are companies with foreign currency income. An exporter that sells goods in dollars can repay a dollar loan from its sales receipts, which acts as a natural hedge. Importers use short-term foreign currency loans to pay suppliers abroad, often alongside a letter of credit or other trade finance. Borrowers without matching income can buy protection through hedging, for example with a forward contract, but that adds cost and is not always available for long maturities.

In Pakistan, banks that are authorised dealers in foreign exchange can use the foreign currency deposits they hold to make trade loans to exporters and importers. These are widely known as FE-25 loans, after the foreign exchange circular that set up the deposit framework, and the State Bank of Pakistan (SBP) sets the rules in its foreign exchange circulars. The rules have changed over time; for example, SBP circulars in 2017 tied the settlement of FE-25 export loans to export proceeds, and a 2012 circular allowed such loans in several major currencies beyond the dollar. The point of the scheme is to let exporters borrow in the currency they earn, linking it to export proceeds repatriation, while keeping the loans tied to real trade.

The best-known warning comes from Central and Eastern Europe. Before 2008, banks in countries such as Hungary, Poland and Croatia sold large numbers of home loans in Swiss francs and euros to households paid in local currency, because Swiss franc interest rates were far lower. When local currencies fell after the 2008 crisis, and again when the Swiss National Bank dropped its cap on the franc against the euro in January 2015, monthly payments jumped. Several governments later forced or encouraged conversion of these mortgages into local currency.

Supervisors treat foreign currency lending to unhedged borrowers as a source of both credit and system-wide risk, because one large exchange rate move can hit many borrowers at once. The European Systemic Risk Board issued a recommendation on lending in foreign currencies in 2011. Common tools include:

• Stricter eligibility. Many central banks limit such loans to borrowers with foreign currency income, as Pakistan's trade-linked scheme does.
• Higher capital or provisioning. Banks may have to hold more regulatory capital against unhedged foreign currency exposures.
• Disclosure and stress tests. Lenders must show borrowers how payments change if the currency falls.

Heavy use of foreign currency loans is also a sign of dollarization, and it can make a country's banks dependent on its foreign exchange reserves in a crisis. When the borrower is the state or a state company, the loan counts toward external debt and, if guaranteed, toward publicly guaranteed debt.

• European Systemic Risk Board