volume (more than 20%) in 2009. Debt overhang in the tradable sector seems, however, to be an issue for a broader set of countries as well: In Bosnia, Turkey, the Slovak Republic, Serbia, the Czech Republic and Croatia more than a quarter of the export-orientated firms are highly leveraged and all of these countries also experienced huge negative shocks to their tradable sector.

# <u>Foreign Currency Lending</u>

Foreign currency (FX) borrowing is seen as a major threat to financial stability in Emerging Europe. More than 70 percent of all private sector loans in Estonia, Latvia, and Serbia are currently denominated in (or linked to) a foreign currency. The share of FX loans also exceeds that of domestic currency loans in Bulgaria, Hungary, and Romania (EBRD, 2010). With regard to debt overhang, foreign currency borrowing is a key potential driver among firms in the region. The substantial depreciation of several currencies before and during the financial crisis imply that those firms which have taken unhedged FX loans now face a substantially higher debt burden, which may constrain their operations and investment going forward. Whether or not FX lending may seriously curb the economic activity of firms in the region depends on the answers to two questions: (1) What share of the firms in the region hold unhedged foreign currency loans? and (2) Are firms with unhedged FX loans predominantly located in those countries where sharp depreciations have taken place?

Several studies using aggregate cross-country data have suggested that FX borrowing is predominantly driven by retail customers taking unhedged currency bets. Luca and Petrova (2008) show that the share of FX loans is higher in countries with higher interest rate differentials. This finding has been supported by Basso et al. (2010) or for example by Rosenberg and Tirpak (2010). Recent firm-level evidence suggests that FX borrowing in the region is not driven predominantly by unhedged customers taking currency bets to benefit from interest rate differentials. Examining the 2005 wave of BEEPS, Brown et al. (2011b) show that only 25% of the loans taken by firms in the ECA region are actually denominated in foreign currency.<sup>8</sup> Importantly, their evidence suggests that those firms which take FX loans are more likely to be hedged against exchange rate risks: FX borrowers are more likely to have export activities, sales to multinational firms or foreign owners than firms which borrow in local currency. This cross-country evidence is backed up loan-level evidence for Bulgaria (Brown et al. 2010) which shows that less risky clients are more likely to apply for and receive an FX loan. At the macroeconomic level both studies suggest that FX borrowing by firms in the region is hardly driven by currency bets: Changes in interest rate differentials over time seem to have little effect on the share of FX loans taken by firms within a country. Indeed, Brown et al. (2011b) find that changes in interest rates over time affects the frequency of FX borrowing in only two countries; Hungary and Serbia.

While FX lending by firms in the region may not be primarily driven by carry-trade behavior, Brown et al. (2011b) point to a non-negligible share of unhedged FX loans in the region. Their analysis suggests that 43% of all FX borrowers in the ECA region do not have

> 8 Evidence from Brown et al. (2010) suggests that the share of FX loans to firms did not further increase in the run up to the crisis. For example, while there was a significant increase in credit volume in Bulgaria between 2005 and 2007, their data shows that the share of FX loans to firms  actually decreased from 37.6% to 33.6%.

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