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Thursday, July 26, 2007

Foreign Currency Lending and Central Bank Options

The following chart comes from The Global Financial Accelerator and the role of International Credit Agencies, a Paper presented to the International Conference of Commercial Bank Economists, Madrid, July 2007 by Carsten Valgreen, Chief Economist, Danske Bank

This data is from 2005, and the position since that time can only have changed in the direction of increased dependence (at least in those countries who started from a low base). This makes the risk level coming from any currency adjustment very clear.

The following is a summary of the content of Carsten's paper:

The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency” economies based on foreign fiat money or gold.

The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.

Here is a summary of the sort of financial transaction which might have been going on in a little corner bank branch, somewhere near you:

Take an arbitrary example: A Polish household wants to buy a second home in France. To do this they contact their local bank (which happens to be the subsidiary of a Swedish-based banking corporation) in order to obtain mortgage finance. They then choose to borrow the money in Swiss francs and Japanese yen. This action is likely to have a large impact on the future income streams and net asset value of this Polish household, and – hence – its future behaviour in the real economy. However, as long as free capital flows are maintained the Polish central bank has limited influence on the transaction. None of it is in Polish zloty. And the credit decision of the private banking corporation extending the credit is taken based on a credit model maintained in Stockholm in Sweden. What will matter for the family is the future currency and rate moves in Swiss francs and Japanese yen. And the price developments for second homes in France. And perhaps also the future credit attitude of a Swedish-based credit institution.

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