This from The Sovereign Society:

Last week, tax-hungry officials from the increasingly socialist countries of Germany and France declared another round in their long running war on Switzerland.

Their aim once again was against traditional Swiss bank secrecy, which the Franco-German politicians claim is little more than a cover for massive tax evasion. As usual, they didn’t offer any proof for this claim.

Over several centuries and during two World Wars, peaceful Switzerland always has maintained its traditional neutrality. It’s kept out of numerous wars involving both…

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

"Herd behavior occurs when people do what others do rather than rely on their own (incomplete) information, which might be suggesting something different (Banerjee, 1992). The suppression of private information could lead to “information cascades” when decisions are made sequentially and a large enough number of people choose identical actions. In such settings, the decisions of a critical few people early on are enough to tilt group behavior toward a certain direction. Mimicking the behavior of others might be rational because of uncertainty about one’s own information as well as the need to economize on information-gathering costs. Rational herd behavior is the subject of a recent strand of behavioral finance (see Montier, 2002, for an introduction). "

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.


The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.


Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research


Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention - at least among theoretical economists) is that of the so called "balance sheet consequences" of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.


In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

"Herd behavior occurs when people do what others do rather than rely on their
own (incomplete) information, which might be suggesting something different
(Banerjee, 1992). The suppression of private information could lead to
“information cascades” when decisions are made sequentially and a large enough
number of people choose identical actions. In such settings, the decisions of a
critical few people early on are enough to tilt group behavior toward a certain
direction. Mimicking the behavior of others might be rational because of
uncertainty about one’s own information as well as the need to economize on
information-gathering costs. Rational herd behavior is the subject of a recent
strand of behavioral finance (see Montier, 2002, for an introduction). "

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.


The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.


Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research


Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention) - at least among theoretical economists) is that of the so called balance sheet cosnequences of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.


In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.