Debt Overhang, Exchange Rates and the Macroeconomics of Carry Trade

The depreciation of the Hungarian forint in 2009 left Hungarian borrowers with a skyrocketing value of foreign currency debt. The resulting losses worsened debt overhang in to debt-ridden firms and eroded bank capital. Therefore, although Hungarian banks had partially isolated their balance sheets from exchange rate risk by extending FX-denominated loans, the ensuing debt overhang in borrowing firms exposed the banks to elevated credit risk. Firms, households and banks had run up the open FX-positions hoping to profit from low foreign rates in the run-up to Euro adoption. This example of carry trade in emerging Europe motivates our analysis of currency mismatch losses in different sectors in the economy, and the macroconsequences of reallocating losses from the corporate to the banking sector ex post. We develop a small open economy New Keynesian DSGE model that accounts for the implications of domestic currency depreciation for corporate debt overhang and incorporates an active banking sector with financial frictions. The model, calibrated to the Hungarian economy, shows that, in periods of unanticipated depreciation, allocating currency mismatch losses to the banking sector generates a milder recession than if currency mismatch is placed at credit constrained firms. The government can intervene to reduce aggregate losses even further by recapitalizing banks and thus mitigating the effects of currency mismatch losses on credit supply.