I bet my house
Borrowing money from the bank is a sophisticated bet on yourself and your capabilities. David Bowie had a strong belief in the quality of his work when in 1997, he issued a ten-year bond with a 7.9% interest rate, backed by his album royalties. Similarly, first few months of the 2010 saw a significant number of people in Slovenia, Croatia and Serbia confidently venturing to buy a real estate using borrowed money and by doing so deciding to sacrifice the lion's share of their income for the next 30 years.
Betting their future income, they made a bet that they will keep their jobs as their second child reaches adolescence. They made a bet that in the meantime they will not get seriously ill. They also made the bet that the variable interest rate to which they agreed will not reach unbearable heights. They are aware that, if any of these bets backfires, the bank will activate the collateral. They have not yet written their The Man Who Sold The Bond, and their income is not enough, so, real estate serves as the collateral. Herein lies another bet. Taking the loan, they made a bet that the value of the property will not fall below the value of the loan. Otherwise, even after the bank sells the house, a negative equity will remain and will have to be covered. For example, during Bowie's contract, the value of his collateral dropped because no one counted on an explosion of pirated music distribution.
But that is not the end to the bets as the loan contract implies another bet. Because house prices are mostly quoted in euros, so the loan is usually indexed in EUR or some other convertible currency. In other words, the debtor made a bet that the currency of his monthly income will not adversely fluctuate in relation to the currency of the loan.
All in all, by taking a loan, the borrower made a series of 30-year bets relating to:
- actual level of economic growth
- variable interest levels
- property value
- local currency vs foreign currency (mostly euros or Swiss francs) exchange rate
Investment funds employ departments with dozens of employees whose only task is the analysis of these and other macroeconomic indicators. Coversely, a housing loan assumes average citizen to summarize all these variables in a single decision. By taking a foreign currency loan, the number of variables to be estimated gets doubled, because apart from his country, the borrower has to assess economic growth, inflation rate and interest rate levels not only in his own country, but also in other countries. In the case of the euro, the borrower must estimate relationships between 16 eurozone members. Obviously, exchange rate is one of the most important components of credit risk, especially, when taking into acoount that this is the only variable that will cause monthly fluctuations between annuities.
Macroeconomics of the exchange rate
And exchange rate fluctuations were nowhere to be escaped from in the past few months. Titles were screaming about the weakening of key world currencies: The pound throws a wobbly. Euro Still Weak. For the Euro's Laggards, Would a Devaluation Help? Countries compete to weaken their currencies. Wen attacks international pressure and insists renminbi is not undervalued. Central bankers, finance ministers and politicians worldwide focused on weakening their own currencies in a classic example of a beggar-thy-neighbor policies.
On the other hand, depreciation talk in Croatia and Serbia causes total horror amongst politicians and citizens alike. In Serbia, newspaper headlines have become increasingly alarming as RSD passed the psychological barrier of 100 dinars per euro. Croatia saw attacks on the governor Željko Rohatinski intensify again. According to critics, the governor is to be blamed for overvalued kuna exchange rate. Strange… Big countries are depreciating their currencies and making every efforts to achieve the goal, while we, having objectively overvalued currencies (based on interest rate and purchasing power parities), are doing everything to prevent their decline. Where do these difference arise from?
In order to explain the differences in approach, it is first necessary to understand the position of the devaluation advocates. To understand their position, it is necessary to recall movements that preceded current situation. Past few decades witnessed continued growth, tamed inflation and low interest rates. This has created an illusion of stability, which led to global imbalances with two basic types of countries, primarily distinguished by their propensity to save.
Saving is nothing less than a deferred consumption. Postponement of current consumption is necessary to accumulate sufficient funds needed to finance investment. Invested in sustainable productive activities, savings will eventually be manifested in the form of goods and services. In other words, more saving than consumption should result in extra manufactured goods, and consequently, with a surplus of current account. Country ant is saving, and thus producing more than it consumes.
However, we are far more often faced with the inverse condition, found in a proverb by which you can not spend more than you produce. This reciprocal position is a logical consequence of the fact that we, as a planet, have not yet developed trade relations with Jupiter. In other words, a surplus of one country necessarily has to materialize itself as a deficit in another country. Average cricket country has had a long period of excess consumption over its saving/production. Extra consumption could not be satisfied by internal means and this resulted in the current account deficit. Since accounts also have to be balanced at the level of individual countries, capital account surplus jumped in to cover current account deficit was covered with the. Capital account includes investments by other countries, which may manifest themselves as an investment in equity and debt securities from financial, non-financial firms, or public sector and less frequently, as greenfield investments.
In a certain year, country, as the sum of the behaviors of its citizens, can spend only what was produced and earned. If that is not enough, an individual can spend what was saved or produced in previous years, for example, grandma's flat. And if he wants to spend even more than that, a person has to borrow. We, crickets, first sold banks and then telecoms. Then we caught borrowing. Just as with Bowie, the money was borrowed on behalf of future income. But, it was spent on goods that do not generate future revenues. It was spent on social expenses, highway construction and real estate - asset classes that have a return of over 30 years.
As the crisis struck in 2007, risk perceptions changed. Sustainability of continuous consumption-based growth came under scrutiny. Capital accounts filled with cheap loans suddenly dried up. A typical cricket country found itself in a situation of double deficit. With imports, despite the consumption drop still surpassing exports, a current account deficit was already there. Then came a budget deficit. Increased revenues from consumption/income taxes (a result of economic growth) and an occasional sale of state assets and licenses, filled government coffers. This led to the proliferation of expenditures. With the fall of economic activity, budget revenues shrank. Unfortunately, to compensate the decline, there are no more assets to be sold. Expenses, however, remain elevated. Especially now, when everybody counts on government spending to required for keynesian revival of the economy and return to employment.
How to get out of this situation? Of course, by encouraging domestic production, especially export orientated, which will simultaneously stop the current account deficit and bring in some taxes. However, production requires savings to finance investments in new plants and that unfortunately takes time. With time being a luxury, the quickest way to increase exports is to increase their competitiveness. And again, as there is no time to invest in quality and modernization, countries must compete in prices or exchange rates.
Whether market-driven and sliding (depreciation), or sudden, by government intervention (devaluation), the weakening of the domestic currency (according to classical economic textbooks) always means the same. Importers must obtain more local currency to pay their euro denominated imports. Imports are becoming more expensive, which in the long run leads to their reduction. At the same time, local exporters are becoming more competitive because their goods are cheaper on international markets. In the long run, exports should increase. However, in the short term, due to consumer demand habits and long-term contracts, quantities remain the same and only the prices change. In the short term, more expensive imports are having a stronger effect, and external trade balance temporarily slides into an even deeper deficit. But in the long run, the demand for more expensive imported goods falls. Foreigners increasingly look for cheaper domestic products - exports grow. Therefore, the recovery of the external trade balance can be described by a J letter shaped curve. Thus, problems can be solved with a small depreciation of, let's say 10%?
Depreciation is overvalued
HNB governor Rohatinski believes there is no such thing as a small depreciation. His view is based on the study of our transition period and the past of our common country. Lengthy periods of intense inflations in the 1970s and 80s saw value of our domestic currency to disappear. Deutschmark and US dollar jumped in as a replacement for eroding dinar. Gaestarbeiters families were more numerous than sailor ones, so german mark won. With the dissolution of the former state, prices have continued to inflate and in 1993 Serbia reached the highest inflation ever in history. At the same year, Croatia managed to restrain inflation. But it was too late. Psychology has been irrevocably altered. Actually, it probably happened much earlier. Prices were negotiated not in tolar, kuna or dinar, but in marks and then euros. The consequences are now everywhere. Just check out your purchase contract. Take a peek on a motorway advertisment. Open newspapers. If we price in euro, depreciation is considered to bring only a new vicious circle.
How? Suppose an individual that receives a salary of 7,500 kuna, which translated with through a 7.5 HRK/EUR exchange rate brings him 1,000 EUR. This individual hardcodes only those 1,000 €, because the prices of items such as a car or an apartment are expressed and quoted in euro. Assume depreciation brings kuna down to 8.0. One week ago, 1 kuna purchased 1 / 7.5 = 13.3 cents. Today, this very same kuna buys only 1 / 8 = 12.5 cents. His salary is no more 1.000, but rather 937.5 €. He negotiates for a raise even though, expressed in local currency, his salary remained unchanged. Paralelly, importers are witnessing their input prices rise, as described by short-term effects of the J curve. If they want to keep margins, importers have to raise prices in local currency. This simultaneous actions show up in an inflation rate. According to purchasing power parity, kuna has to depreciate again. High inflation should also be reflected in higher interest rates. Interest rate parity, according to theory, should lead to new depreciation. Theoretically, this can happen indefinitely.
Who is right?
The economy of a country is a mechanism driven by decisions of millions of individuals, therefore, one cannot run a controlled experiment to determine which approach would bring more benefits. For something that is true in macroeconomic textbooks does not apply in all realities and in all periods. While discussions on a model that would best serve our needs linger on, governors keep playing with the reserves, waiting for the inflows from tourist season or remaining state assets sale, all the time acting to prevent capital flight.
However, all their actions are bringing only short term benefits. Both positions also agree that the focus on structural problems. Because actually, nominal exchange rate should not have a decisive impact on the foreign trade balance. Kuna may be widely overvalued, but it has been stable, for almost the entire last decade. Is not this a sufficiently long period in which exporters had their chances to adjust to kunas overvaluation, and instead of depreciation agenda, focus their efforts on increasing their competitiveness?
But, if the exchange rate is actually irrelevant in the long run, why it has to be overvalued? Because we learned that there is a self-feeding mechanism by which depreciation leads to inflation which in turn brings another depreciation wave. Opposite to this, pegged exchange rate protects against inflation. Pegging the exchange rate to the currency of a country with a low inflation, a low inflation is imported. By that, exchange rate actually becomes an instrument of a monetary policy. And structural imbalances are not solved with the exchange rate, but by changes in the level of investment and savings. But it takes time.
We look at local currencies, but through euro glasses
Because we do not believe the local currencies, we save in euros, swiss francs or US dollars. Wages are received in local currencies, and brought to the bank, converted into euro and deposited. On the matruity date, bank will have to return us euros. But we brought local currency and on that day cash desk received kunas or dinars. Since the central bank regulates the maximum open foreign currency position (currency mismatch between assets and liabilities), banks must change their assets from dinar to euro. How do they do it? By issuing loans in pure euro, or through loans with a currency clause.
Euroisation is bes reflected in the financial sector. Most of the loans are indexed in euros, so any weakening of the domestic currency through depreciation or devaluation would increase the residual value of debt expressed in domestic currency. It would also increase the amount of monthly installments. Ministers are aware of it, and it is correctly assumed that the depreciation would be a rather unpopular move brodering even with a political suicide.
Banks have other options to reduce their open positions, and that is to increase deposits in local currency. But nobody wants to save in kuna or dinar for the fear that it will weaken while deposit expires. Therefore, banks are forced to offer much higher interest rates on dinars to attract depositors. The interest rate parity says that the money is worth as much as you can earn on it. A parity is reached if euros bring you 5%, while dinar pays 12%, with 7% on the behalf of depreciation then. Of course, more expensive dinar deposits reflected expensive dinar loan.
Therefore, our loans are in euro because we save in them. What we do end up saving in local currency, banks give us back through more expensive loans. Higher interest rates of local currency denominated loans further add to the demand for eur ones. Simply put, they are more affordable. Pricing is clearly strong enough, because for the same reason, the Slovenes, Austrians and Poles also borrowed in swiss francs. Although CHF interest rates were lower than the euro ones, will they remain lower for the next few decades? Why do borrowers prefer a saved dollar today for the uncertain situation in the future?
Psychologically speaking, for an individual faced with a choice between two seemingly equally risky things, the risk of any of the selected options will be interpreted as lower, because of the illusion of control. The debtor chooses between two options. He has a full control to choose between one of them. This control of selection creates the illusion of risk control. Moreover, if a selected choice brings benefits (although these benefits may be questionable in the long term), the perception of risk falls further.
In other words, if the borrower can choose between borrowing in euros at 5% and 3% in CHF, he will choose CHF, because the current savings of 2% leads him to underestimate the risks associated with his decision, and the very selection creates an illusion that a risk can be controlled in the same way as choice was.
Currency-induced credit risk
Interest and exchange rates are unfortunately managed by a somewhat stronger mechanisms. Guided by the flawed logic and good intentions, clients entering into a foreign currency loan are becoming exposed to interest and exchange rate risk. For example, although CHF interest rate was lower than the EUR one in the beginning of this century, last thirty years (standard maturity of residential mortgage loans) witnessed periods in which there was almost no difference, and also years in which interest in EUR was lower than the CHF one. Of course, economies of Switzerland and EU are deeply linked and it is difficult to repeat the early eighties of last century when the interest rate differential amounted to 6 percentage points. If, however it happens, clients are usually left with an option to convert to another currency, which bears some costs and can eat into all of the earlier savings.
Although loan contracts banks transfer exchnage rate risk onto their clients, these same risks return reducing the quality of loan portfolios. Clients for which exchange rate increased over unbearable limits, will be forced to miss a loan payment. Consequent increases in provisions can consume the entire profit or in a worse case, the capital of a bank.
How to assess the risk of currency-induced credit risk? Historical data is not good enough because there is no sufficiently long time series to be able to draw relevant conclusions from them. In addition, the last decade is not a representative sample, because it was marked by the stable exchange rate and relatively low level of provisions. There is also the problem of confusing correlation and causality. The fact that the exchange rate increased does not necessarily mean that it increased the provisions, because the increase in provisions can be caused by other reasons, such as unemployment. However, it si logical to expect that variables such as exchange rate, unemployment and provisions, if nothing else, then at least move in the same direction.
This scenario played out with crisis and a chain reaction resulting from the withdrawal of foreign capital from local banks, forcing them to engage in a fierce fight for every euro, dollar or dinar of savings. For the foreign capital that remained, increased perception of risk has led to higher required rates of return. Despite central banks measures aimed at regulatory relaxataion in areas to create cheaper source of funds, deposit interest rates overall, increased. This has cascaded back to citizens and businesses. In addition to interest rate risk, the borrowers are caught on with foreign exchange risk, especially in Serbia, where dinar has lost over 20% since the crisis first struck. While unemployment reaches new record levels, many borrowers are witnessing their installments increase and eat into their remaining savings. Many of them have no savings left. The results are seen in the balance sheet and profit and loss account of banks. On this subject, it would be interesting to see the recent results of stress tests similar to those that were presented at a conference of the Zagreb money market from early 2007. Since then, credit exposure has continued to grow, significantly in euros as the banks followed the trend to safety.
So, should we borrow in foreign or local currency? Since the exchange rate is primarily a function of the strength of the economy, it might be best to wait to see what happens with our public finances and foreign trade balances. State leaders are trying to encourage investment and exports, but there is no cheap money to finance it. Now it comes with higher interest rates. While the cheap money kept coming in, it was spent on new cars and purses. Now, we must choose between a new, more expensive debt, or belt tightening. Hard choices are in front of our populist prime ministers. If only there Alexander the Great to cut this Gordian knot. What do you say, he is Greek? Quite a good reference.