Exchange rate risk

Sometimes the form of the debts can help us understand financial crises.In the Mexican, Asian, and Turkish crises, private borrowers took on large liabilities denominated in foreign currency while acquiring assets valued in local currency.The borrowers took on these positions exposed to exchange rate risk because they expected that the governments would continue to defend the fixed or heavily managed exchange rate value of the foreign currency.A major part of this uncovered foreign borrowing was the “carry trade”, in which financial institutions borrow dollars or yen at a low interest rate, exchange the money for local currency, and lend in the borrowing country at a higher interest rate.This is very profitable as long as the exchange value of the local currency is steady.

When the likelihood of devaluation or depreciation becomes noticeable, the borrowers attempt to hedge their exposed positions by selling local currency, putting additional pressure on the government defense of the fixed exchange rate.If the government gives up the fixed rate, borrowers suffer losses to the extent that their positions are still un-hedged.The losses make it more difficult for them to service their foreign debts.Foreign lenders then may reduce new lending and try to be repaid more quickly, leading to a financial crisis.