Foreign currency loans (borrowing) is a common phenomenon in developing economies and it is gaining popularity. Although the loans denominated in foreign currencies are oftentimes cheaper than those in the local currency, they expose the firms (borrowers) to exchange rate risk.
When it comes to foreign currency loans, exchange rate risk, or currency risk, is the financial risk that fluctuations in the relative value of a particular currency can change (mostly increase) the value of the loan denominated in a foreign currency. This can affect the borrowers’ ability to service their debts, resulting in a credit risk.
How credit risk arises
The negative impact on the borrowers’ economic performance due to exchange rate fluctuation has some ripple effects. The firm may lose its investments, lay off employees, reduce the scale of operations, and eventually not be in a position to pay its debt obligations. The inability to pay loans gives rise to credit risk for the banks (lenders). However, this occurs where the borrower had not properly hedged against the exchange rate risk. Credit risk can be defined as the risk of defaulting on a debt that comes about when the borrower fails to repay as agreed with the lender.
Credit risk is primarily faced by the lender and is comprised of:
Ø Lost principal and interests
Ø Interference with lender’s cash flow
Ø Increased debt collection costs
Reasons for borrowing in foreign currency
So, why would firms borrow in foreign currency and not local currency? Well, the following are some reasons:
- Foreign currency loans may be inexpensive compared to local currency loans.
On average, interest rates on foreign currency loans are lower than local currency loans.
- Firms want to hedge against exchange rate risk.
The risk may arise from proceeds in foreign currency or assets denominated in foreign currency. According to some financial experts, borrowing in Eastern Europe in foreign currency is driven mainly by foreign currency income.
- Banks want to match the currency structure of assets with that of liabilities.
This is a supply-driven factor unlike the first two which are demand-driven, thus even supply factors could influence foreign currency borrowing to some extent.
Due to the above reasons and others, firms seek to get foreign currency loans. As is the case with local currency loans, lenders need to be convinced that the borrower will repay by looking at their credit score. The approval of the loan application and the interest rate charged will depend on the score. However, if the score is bad, the borrower can still work on improving it, and one way is by engaging experts in credit score rebuilding such as Boostcredit101.
How borrowers protect themselves when borrowing foreign currency loans
Due to the exposure to exchange rate risk, the financial market offers various instruments for borrowers to hedge (protect) against the risk. Firms can hedge against foreign exchange risk through strategies like foreign exchange swaps or natural hedges (income in foreign currency). Unfortunately, the strategies for hedging may be costly or unavailable for some firms, making some borrowers not to take them, thus remaining unhedged (unprotected) against the risk. In such circumstances, when the value of the domestic currency depreciates, the borrowers’ debt obligation increases, causing negative effects to the borrowers’ economic performance.
Foreign currency loans is a financing method used especially in emerging economies, and it is preferred for being cheaper than local currency loans. However, due to exchange rate risk, a borrower can find that the value of their loan has increased if the local currency depreciates. The increased loan can affect the business’s profitability, making it unable to meet its debt obligation, resulting in credit risk to the lender. Hedging against exchange rate risk can help to protect the borrowers from currency risk.