Jason Marshall, MPP, Staff Writer, Brief Policy Perspectives 

After the Great Recession came the New Normal. The worst economic downturn in the U.S. since 1929 has decreased annual GDP growth by  .5% – 1% when compared to pre-recession average growth rates, and significantly decreased the returns of financial securities in economically advanced countries. In response, investors have turned toward emerging market economies (EMEs), whose higher risk can potentially yield higher returns. As this occurs, EMEs, which include nations throughout Asia, Africa, Eastern Europe, Latin America, and the Middle East, are liable to encounter a condition called currency mismatch. Currency mismatch describes the practice of holding liabilities in a foreign currency, such as the U.S. dollar or the euro, while assets are held in the less-stable domestic currency.

This practice has a dual effect, as described by Romain Ranciere, Aaron Tornell and Athanasios Vamvakidis in a collaborative piece entitled, “Currency Mismatch, Systemic Risk and Growth in Emerging Europe.”

“On the one hand, currency mismatch has …  resulted in large exposures to systemic risk for the [EME] economy as a whole. On the other hand, it has been an engine of credit growth that has allowed new and small firms to finance profitable investment projects.”

A deliberate plan from the World Bank, or other international finance organizations, to maximize the benefits of currency mismatch while mitigating the potential for, and the size of, the systemic risks to EME’s would serve as a valuable tool for all stakeholders, including investors and borrowers. Advanced economies are opening up their pocketbooks to the developing world; while that investment ought to be encouraged, steps must be taken to ensure that the EME’s are not exposed to unnecessary risk.

The value of currencies are constantly in flux. Just as inflation or deflation can increase or decrease the spending power of a dollar, for example, appreciation or depreciation of one currency against another can do the same at the global level. This fluctuation is accentuated when debts and liabilities are held in two different currencies. For example, in 2007, Airbus estimated that a 10 cent appreciation of the euro against the U.S. dollar would increase their debt by one billion euro in real terms because the majority of its revenue was received in USD while its operating costs were paid in euro. The revenue stream in dollars was not worth as much as the simultaneous expenses going out in euros.

Currency mismatch is heightened in EMEs as domestic currencies (the currency of the EME) are far more susceptible  to factors influencing stability than the currencies of advanced nations. In an extreme example, the Ukrainian Hryvnia has decreased 68% against the U.S. Dollar since the 2014 revolution and subsequent annexation of Crimea. Ukrainian firms borrowing in USD saw their debts explode in real terms, as they continue to struggle to pay back in devalued Hryvnia.As explained in a report by the Bank for International Settlements;

“If such risks materialize, the creditworthiness of some corporations could worsen, pushing up bond yields [interest rates for financing debt.] Higher financing costs and tighter funding conditions for firms could then become a drag on economic growth… All in all, such developments could generate powerful feedback loops in response to exchange rate shocks.”

The flip side to potential financial devastation is, of course, profits. In periods of economic tranquility, firms can afford to take on leverage, borrow  more on their assets, and see greater returns. This in turn leads to greater levels of overall economic growth, a benefit that should not be taken lightly in EMEs. Even with the systemic risk associated with over-leveraging with foreign currency, it would not be wise for policymakers to eliminate a tool that stimulates and encourages growth.

What is needed is a compromise.

Taking away an emerging country’s ability to tap into more stable capital markets because its own currency is more volatile would be like using a sledgehammer when a scalpel will do. It would be heavy-handed and hurt far more than it would help. EMEs would benefit tremendously from gaining access to the entire range of financial tools that firms in developed markets take for granted. The complete tools under-utilized by EMEs  fall into two broad categories: Hedging and bailouts.

Hedging is a concept to describe any action firms take to reduce uncertainty. In the case of currency mismatch, firms can hedge using foreign exchange derivatives (three different, yet related, financial instruments). Essentially, firms can purchase insurance that will pay out at a predetermined rate. Therefore, if the domestic currency depreciates, the firm will recover some of their losses at that predetermined rate. These instruments are found in EMEs, but are more prevalent in  more developed (by-comparison) markets such as Hong Kong and Singapore, which made up 69% of the derivative market investments in 2010. In comparison, India’s market participation consisted of only 2% and the Ukraine even less. By encouraging firms in EMEs to utilize these instruments, and encourage financial firms in advanced economies to offer them, the risk of systemic failure is reduced greatly.

The other instrument is implicit in most cases of currency mismatch: the role of a bailout by a third party actor such as the World Bank. Without the implicit guarantee of a bailout, creditors would have to charge a risk premium on EME borrowers to protect against the risk of currency deflation and subsequent default. This premium would mitigate the positive growth effects of currency mismatch, rendering it untenable. A World Bank managed fund, with contributions from the membership countries, held in stable currencies, could serve as an explicit source of bailout funding if the need arises. This fund would serve as a form of insurance; only being used if there is an agreed amount of currency deflation that occurs in a contributing country or market. With some guarantee of a bailout, developed firms could invest in EMEs with a reasonable amount of confidence.

Emerging markets should welcome investment and the growth that comes along with it. The inherent risks involved with currency mismatch are real and can exacerbate economic downturns during periods of instability. However, these risks can be hedged through financial instruments such as foreign exchange derivatives or a World Bank managed bailout fund. Financial sectors in advanced economies have long since benefitted from learning to manage risk. Those same lessons can be utilized in emerging markets to the same result.