Croatia Swiss Franc Peg Raises Stability Questions


In the midst of last week’s ECB-wrought jubilation, something strange happened. Croatia, if the press is to believed, took steps to fix its exchange rate against the Swiss Franc. This is strange for a couple of reasons, first of all the country’s government apparently did this in order to dampen the effect of last week’s price spike on Franc denominated mortgage holders. Secondly, the country is the newest member of the European Union, and is committed to join the Eurozone.

First thing’s first: why would anybody in their right mind take out a loan in another currency? This has apparently been a big deal in Eastern Europe for a decade, and is at the heart of a lot of financial and political problems on the less followed half of the continent.

A country can’t simply peg its currency to the Swiis Franc and remain on track to join the Euro. It’s not part of the EMU mandate. Why would a government jeopardize its future inside the Eurozone in order to save mortgage payments? The answer is that Croatia did not peg its currency at 6.39 kuna per franc, and media outlets appear to have gotten that point completely wrong.

Without a Croatian researcher, it’s difficult to get the story straight, but the markets appear to be saying that the loans have been fixed on exchange rate, not the entire currency. This may still be dodgy on a European Union level, but there’s something even more interesting going on.

Finding arbitrage

If a currency has two exchange rates and no exchange fees, given free choice you should be able to circulate money until you become infinitely rich or, as is more common in financial markets, the spread between them closes until both are the same, or transactions costs destroy any benefit. This is a process called arbitrage, and it’s the way markets stay efficient, and some actors are able to make money consistently without having to pick winners.

This is a little more complicated than that, however, as it involved fixed exchange rates on a payment in a single direction, on a particular type of loan, i.e. paying a bank 6.39 kuna today for a loan the markets say is worth 7.7 kuna. You could, theoretically, purchase real estate for less than it’s actually worth on the books of those banks, and sell it on for a guaranteed profit.

Unless there’s someone out there with a good understanding of these loan agreements and the moves the government just made, however, it’s better to assume that there’s a huge restriction on this kind of movement. If you have access to those kinds of resources i.e. a Croatian legal team and real estate buyer, it may be worth looking into.

There’s also the matter of high transaction costs in real estate and the fact that Croatian house prices have been very unstable in recent years to worry about, but the core of the idea is there.

Croatian bonds yields crash

Assuming these loans are restricted from the kind of arbitrage described above, there are other ways to play this market movement that have been confused by the media’s announcement of a full currency conversion. Croatia’s bonds fell along with everyone else’s last week, but the country’s government, already facing years of stagnation, is now likely going to be paying the difference on the exchange rate for the next year, despite protestations that the banks would take the hit.

On top of that, the government is considering launching a Hungary-inspired loan conversion program. The Hungarian program is not finished yet, but you can assume it’s going to be expensive. The Swiss Franc denominated loans in Croatia are equal to about 7% of the country’s 2013 GDP, meaning that there could be serious stability issues if the government, already in financial difficulty, has to shell out to lower the cost of the loans to householders.

Banks in the country, like Erste Bank, a Vienna based house are suffering. That company, which holds loans like this across Eastern Europe saw a derivative based on its shares collapse directly after the decision. Despite all of the momentum building behind really unpredictable risks, the country’s bond yields collapsed after the ECB easing announcement.

Betting against the country’s bonds is very risky, as the 10 year yield sits well above comparable European securities, but, given the financial storm the country may be sitting atop of, now might be the time to get studying the securities and the government’s budget.

If anybody out there does have more information about the Croatian currency cap, please get in touch.

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