## _wp10263

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### I. Introduction: currency mismatch as systemic risk and growth engine
- Definition: currency mismatch is the extent to which an economy’s liabilities are denominated in foreign currency while its assets are denominated in domestic currency.
- Key points:
  - Currency mismatch is a main mechanism for systemic risk; historical crises cited include Mexico 1994 and East Asian 1997–98.
  - During the precrisis boom, emerging Europe saw unprecedented levels of currency mismatch; in 2007 the share of foreign currency lending to total lending reached well above 50 percent in most emerging European economies.
  - Currency mismatch can facilitate growth by allowing financially constrained firms (for example, new and small firms) to finance profitable investment projects.
  - Trade-off: macro-prudential limits or capital controls that reduce currency mismatch when low could hurt investment and growth, especially for small and medium enterprises; excessive currency mismatch risks severe crisis after abrupt devaluation.
- Limitations of straightforward measures:
  - Net national debt or debt service requirements to net exports — captures external aggregate imbalances but not sectoral concentration in borrowers without foreign currency income.
  - Ratio of foreign currency denominated liabilities to foreign currency denominated assets of the banking sector — tends to show small notional mismatch because banks with foreign currency liabilities often lend in foreign currency; does not capture indirect exposure when borrowers are unhedged.

### II. Rationale for a new de-facto currency mismatch measure
- Shortcomings of aggregate and bank-balance-sheet measures:
  - May miss sectoral imbalances and indirect channels of systemic risk when borrowers lack foreign currency income or effective hedges.
- Indirect exposure mechanism:
  - If borrowers cannot hedge, banks are indirectly exposed to exchange rate risk through credit risk: following an abrupt devaluation, foreign currency loans to unhedged borrowers may become nonperforming and threaten banking capital and systemic stability.
- Desirable attributes of a measure:
  - Control for indirect channels by which foreign currency debt generates insolvencies across different classes of bank debtors.
  - Account for sources of foreign currency income for different classes of foreign currency borrowers.
- Data constraint:
  - Detailed composition of banks’ assets and liabilities and hedging status of borrowers is limited, constraining existing measures.

### III. Construction of the de-facto currency mismatch measure
- Core definition:
  - De-facto currency mismatch measure = foreign currency denominated net unhedged liabilities / total bank assets.
- Numerator determination:
  - The numerator is the share of banks’ net foreign currency liabilities that is lent to unhedged borrowers; those loans are effectively subtracted from the asset side of banks’ balance sheets.
- Data sources combined:
  - Banks’ foreign currency assets and liabilities.
  - BEEPS firm-level data.
  - Other data from national authorities.
  - IMF’s confidential Vulnerability Exercise for Emerging Economies.
- Purpose:
  - Explicitly account for the part of banks’ foreign currency assets that are loans to borrowers with no foreign currency income and thus indirectly subject to exchange rate risk via credit risk.

### IV. Formula and components (Appendix material)
- Exact formula (as stated in source):
  - Foreign currency denominated net unhedged liabilities / total bank assets = {[foreign currency foreign liabilities + foreign currency domestic liabilities] - [foreign currency foreign assets + foreign currency domestic assets] + [foreign currency lending to unhedged households + foreign currency lending to unhedged nonfinancial firms]} / [total bank assets]
- Components (defined exactly as in source):
  - Foreign currency foreign liabilities: foreign currency claims of nonresidents towards the domestic banking sector (i.e., loans of foreign banks, including parent foreign banks to their subsidiaries, and foreign currency deposits of nonresidents).
  - Foreign currency domestic liabilities: foreign currency claims of residents towards the domestic banking sector (i.e., foreign currency deposits of residents).
  - Foreign currency foreign assets: foreign currency claims of the banking sector towards nonresidents (i.e., deposits, or loans in foreign currencies).
  - Foreign currency domestic assets: foreign currency claims of the banking sector towards residents (i.e., foreign currency loans).
  - Foreign currency lending to unhedged households: part of banks’ foreign currency domestic assets that is foreign currency lending to unhedged households.
  - Foreign currency lending to unhedged nonfinancial firms: part of banks’ foreign currency domestic assets that is foreign currency lending to unhedged firms.

### V. Rationale for the adjustment and caveats
- Why add foreign currency lending to unhedged households and firms to the numerator:
  - Such lending is subject to exchange rate risk through balance sheet effects in households and nonfinancial firms.
  - A sharp exchange rate depreciation could turn a large share of such loans into nonperforming loans.
  - A borrower’s currency mismatch can translate into a bank’s currency mismatch if the borrower cannot repay the foreign currency loan during a crisis.
- Caveat noted in source:
  - The measure assumes exporters are able to hedge all exchange rate risk, but loans to borrowers with foreign currency income may still be unserviced during a crisis if foreign income declines. Example statistic: emerging Europe’s exports of goods and services fell by 11 percent in volumes, or 21 percent in nominal U.S. dollars, in 2009.

### VI. Data requirements, construction choices, and robustness
- Required data:
  - Refined bank balance sheet data tracking credit to sectors (households, nonfinancial firms) and hedging status of debtors.
- Primary data sources used:
  - Haver Analytics.
  - Internal and confidential IMF Vulnerability Exercise for Emerging Economies.
  - Share of foreign currency lending to corporates with no foreign currency income from EBRD and World Bank firm survey data, country authority data, and country studies.
- Treatment of households’ hedging when data limited:
  - Two alternatives computed: households hedge to same extent as firms, or households do not hedge at all.
  - For an additional 19 emerging economies where data are only for the whole private sector, the measure assumes households’ hedging is the same as firms’.
- Robustness checks:
  - Results tested dividing measure by GDP instead of total bank assets.
  - Comparison using IMF IFS data (which do not specify currency denomination) assumed all banks’ foreign assets and liabilities are in foreign currency for some countries; simple correlation of changes between IFS-based measure and baseline is 0.85.
- Survey and threshold assumptions (exact thresholds used in source):
  - Company with share of foreign currency loans in total loans higher than 30 percent considered subject to exchange rate risk.
  - Company selling more than 70 percent domestically labeled as nonexporter.
  - Results reported as robust to alternative thresholds.

### VII. Empirical scope and key comparative findings
- Coverage and samples:
  - Detailed measure constructed for 10 emerging European economies with detailed balance sheet data over the period 1998–2008.
  - A similar de-facto measure computed for 19 additional emerging economies for which less detailed data are available.
  - Ten detailed emerging European countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Ukraine; these economies account for 86 percent of East Europe’s GDP, excluding Russia.
- Trends and magnitudes:
  - Currency mismatches increased throughout emerging Europe during the boom years before the recent crisis, particularly in Bulgaria, Latvia, Estonia, and Lithuania.
  - On average, currency mismatches as a share of bank assets increased by 16 percentage points during the last ten years in the region.
  - Difference between unadjusted versus adjusted measure: the difference is on average equal to 23 percentage points; differences particularly sharp in Estonia, Latvia, and Bulgaria.
  - Before the crisis, the currency mismatch measure reached the highest level in Romania, Estonia, Croatia, Latvia, and Lithuania.
  - The only economies without currency mismatches before the crisis (a negative measure in 2007) included the Czech Republic and, less so, Ukraine.
- Sectoral allocation of unhedged lending (precrisis):
  - Most unhedged foreign currency borrowing was done by firms; however, unhedged foreign currency borrowing by households increased substantially by 2007 (reflecting mortgage-financed housing booms).
  - Assuming households hedge as much as firms or not at all produces similar currency mismatch measures (correlation between the two close to one).
- Direct corporate foreign borrowing:
  - Firms’ direct foreign currency borrowing from abroad increased currency mismatch in all sample countries before the crisis.
- Cross-country comparisons (extended sample):
  - Emerging Europe stands out with the largest currency mismatch before the crisis.
  - The six economies with the largest currency mismatch in 2008 were all in Europe: Romania, Bosnia and Herzegovina, Estonia, Lithuania, Croatia, and Latvia.
  - The six economies with the largest increase in currency mismatch before the crisis (2004–07) were in emerging Europe: Estonia, Latvia, Bulgaria, Ukraine, Lithuania, and Serbia.

### VIII. Comparisons with standard measures and policy implications
- Comparisons with alternative measures:
  - Alternative measures include net external debt to exports of goods and services and external debt service to exports of goods and services.
  - The new measure provides additional information: levels of net external debt to exports appear highly correlated with the new measure, but the correlation of changes is very small. External debt service to exports is even less correlated with the new measure in levels and changes.
- Policy implications and recommended monitoring:
  - The de-facto measure (foreign currency denominated net unhedged liabilities / total bank assets) captures indirect exposure of banks to foreign exchange risk through credit risk and is much larger than measures that do not adjust for unhedged lending.
  - Policymakers should monitor both direct mismatches in banks’ balance sheets and indirect imbalances via borrowers’ ability to repay foreign currency debts.
  - The measure can flag excessive currency mismatch that could call for macroprudential measures, but it can also indicate when mismatch is at comfortable levels—avoiding unnecessary policy that could cause a credit crunch.

*Source: _wp10263 — IMF PDF (References and Appendix excerpts)*

### References .............................................................................................................

### References

### I. Introduction: currency mismatch as systemic risk and growth engine
- Currency mismatch defined as the extent to which an economy’s liabilities are denominated in foreign currency while its assets are denominated in domestic currency.
- Currency mismatch is one of the main mechanisms by which emerging economies take on systemic risk; cited historical crises include Mexico 1994 and East Asian 1997–98.
- During the precrisis boom, emerging Europe experienced unprecedented levels of currency mismatch; in 2007 the share of foreign currency lending to total lending reached well above 50 percent in most emerging European economies.
- Currency mismatch can also facilitate growth by allowing financially constrained firms (for example, new and small firms) to finance profitable investment projects.
- The trade-off: introducing macro-prudential measures or capital controls to limit currency mismatch when it is low could hurt investment and growth, especially for small and medium enterprises; allowing excessive currency mismatch could lead to a severe crisis after an abrupt devaluation.
- Existing straightforward measures:
  - Net national debt or debt service requirements to net exports — captures external aggregate imbalances but not sectoral concentration in borrowers without foreign currency income.
  - Ratio of foreign currency denominated liabilities to foreign currency denominated assets of the banking sector — tends to find small notional mismatch because banks with foreign currency liabilities often lend in foreign currency; does not capture indirect exposure when borrowers are unhedged.

### II. Rationale for a new de-facto currency mismatch measure
- Shortcoming of aggregate and bank-balance-sheet measures: they may miss sectoral imbalances and indirect channels of systemic risk when borrowers lack foreign currency income or effective hedges.
- If borrowers cannot hedge, banks are indirectly exposed to exchange rate risk through credit risk: following an abrupt devaluation, foreign currency loans to unhedged borrowers may become nonperforming and threaten banking capital and systemic stability.
- A suitable measure should control for indirect channels by which foreign currency debt generates insolvencies across different classes of bank debtors and account for sources of foreign currency income for different classes of foreign currency borrowers.
- Data availability constraint: detailed composition of banks’ assets and liabilities and the hedging status of borrowers is limited, constraining existing measures.

### III. Construction of the de-facto currency mismatch measure
- Core definition: the de-facto currency mismatch measure is computed as the ratio of foreign currency denominated net unhedged liabilities to total bank assets.
- The numerator (foreign currency denominated net unhedged liabilities) is determined by the share of banks’ net foreign currency liabilities that is lent to unhedged borrowers; those loans are subtracted from the asset side of banks’ balance sheets.
- Data sources combined to construct the measure include:
  - Banks’ foreign currency assets and liabilities.
  - BEEPS firm-level data.
  - Other data from national authorities.
  - IMF’s confidential Vulnerability Exercise for Emerging Economies.
- Purpose: explicitly account for the part of banks’ foreign currency assets that are loans to borrowers with no foreign currency income and thus indirectly subject to exchange rate risk via credit risk.

### IV. Empirical scope and key comparative findings
- Countries and periods covered:
  - Detailed measure constructed for 10 emerging European economies with detailed balance sheet data over the period 1998–2008.
  - A similar de-facto measure computed for 19 additional emerging economies for which less detailed data are available.
- Comparative result: the new de-facto currency mismatch measure is much larger than other currency mismatch measures that do not control for banks’ borrowers’ ability to hedge.
- Empirical tables and figures (listed in the source):
  - Tables: Currency Mismatches in Emergency Europe in Percent of Bank Sector Assets: Adjusting for Unhedged Borrowing, 2004–07; Currency Mismatch Measures in Emerging Europe, 2004–07; Appendix Tables including Currency Mismatch Data.
  - Figures: Bank Loans in Foreign Currency in Percent of Total Bank Loans, Emerging Europe, 2007; Currency Mismatch in Emerging Europe, 1998–08; Currency Mismatches in Emerging Europe, with and without Adjustment for Unhedged Lending, 2007; Currency Mismatch in Emerging Economies, 2008; Increase in Currency Mismatch in Emerging Economies before the Crisis (2004–07).
  - Appendix: Calculation of Currency Mismatch and Data Sources; Appendix Tables with currency mismatch data (including an alternative using only IFS data for foreign assets and liabilities).

### V. Policy implications and measurement use
- A good measure of currency mismatch can help authorities strike the right balance between allowing foreign-currency financing that supports investment (particularly for small and medium enterprises) and limiting excessive vulnerabilities that raise crisis risk.
- The de-facto currency mismatch measure addresses the need to capture indirect systemic risk through unhedged foreign currency lending and can better inform macro-prudential policy decisions and crisis-prevention efforts.

*Source: _wp10263 - References (excerpt) — IMF PDF*

### Appendix for details.) The formula of the new currency mismatch measure in the banking

### References

### References

### Cited works

- Arteta, Carlos O., 2005, “Exchange Rate Regimes and Financial Dollarization: Does Flexibility Reduce Currency Mismatches in Bank intermediation?” B.E. Journal of Macroeconomics: Topics in Macroeconomics, Vol. 5(1), pp. 128.

- Arteta, Carlos O., 2003, “Are Financial Dollarized Countries More Prone to Costly Crises?” International Finance Discussion Paper No. 763, Board of Governors of the Federal Reserve System.

- Eichengreen, Barry, Ricardo Hausmann, and Ugo Panizza, 2007, “Currency Mismatches, Debt Intolerance, and the Original Sin: Why They Are Not the Same and Why It Matters,” in Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, edited by Sebastian Edwards, NBER, University of Chicago Press.

- Goldstein, Morris, and Philip Turner, 2004, “Controlling Currency Mismatches In Emerging Markets,” (Washington: Institute of International Economics).

- Hilaire, Alvin, and Anna Ilyina, 2007, “External Debt and Balance-Sheet Vulnerabilities in Croatia,” in Republic of Croatia: Selected Issues, (Washington: International Monetary Fund).

- Kamil, Herman, 2010, “How Do Exchange Rate Regimes Affect Firms’ Incentives to Hedge Currency Risk in Emerging Markets?”, unpublished, (Washington: International Monetary Fund).

- Kamil, Herman, 2004, “A New Database on the Currency Composition and Maturity Structure of Firms’ Balance Sheets in Latin America, 1990–2002: Definition of Variables, Methodology of Construction and Data Sources,” Inter-American Development Bank Database. Available via the internet: http://www.iadb.org/res/pub_desc.cfm?pub_id=DBA-001.

- Prat, Stephanie, 2007, “The Relevance of Currency Mismatch Indicators: An Analysis through Determinants of Emerging Market Spreads,” Economie Internationale, No 111(3).

- Ranciere, Romain, Aaron Tornell, and Athanasios Vamvakidis, 2010, “Currency Mismatch, Systemic Risk and Growth in Emerging Europe,” Economic Policy, forthcoming.

- Rosenberg, Christoph, Ioannis Halikias, Brett House, Christian Keller, Jens Nystedt, Alexander Pitt, and Brad Setser, 2005, “Debt-Related Vulnerabilities and Financial Crises: An Application of the Balance Sheet Approach to Emerging Market
Countries,” IMF Occasional Paper No. 240 (Washington: International Monetary Fund).

- Rosenberg, Christoph, and Marcel Tirpak 2009, “Determinants of Foreign Currency Borrowing in the New Member States of the EU,” Journal of Economics and Finance, Vol. 59 (3), pp 216–28.

- Sorsa, Piritta, Bas Berend Bakker, Christoph Duenwald, Andrea M. Maechler, and Andrew Tiffin, 2007, “Vulnerabilities in Emerging Southeastern Europe—How Much Cause for Concern?” IMF Working Paper No. 07/236 (Washington: International Monetary Fund).

*Source: _wp10263 - References*

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