Giovanni Staunovo, strategist, giovanni.staunovo@ubs.

com, UBS AG

Wealth Management Research

6 July 2010

Currency markets
Franc loans might become a threat for Switzerland
s Over the past decade, many households and companies outside

of Switzerland, particularly in Austria and several Eastern European countries, took out loans denominated in Swiss francs to finance their local investments in their home currency.
s The total amount of Swiss franc loans outstanding outside of

Fig 1. Outstanding Swiss franc loans abroad to banks and non-banks In billions of Swiss franc
600 550 500 450 400 350 300 250 200 150 100
99 00 01 02 03 04 05 06
Hungary other

1.70 1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30 07 08 09
Eurozone Croatia UK Denmark Poland EURCHF (rhs)

Switzerland remains remarkably high, despite the fact that the amount has declined slightly since autumn 2008. As a consequence of the franc's sharp appreciation, some investors did not renew maturing loans and in some countries it is even now prohibited to take out lowyielding foreign currency loans. So far, there is, however, no evidence that borrowers are systematically unwinding foreign currency loans.
s The franc's rapid appreciation remains painful for foreign borrowers,

as the amount of their franc-denominated debt has increased remarkably in their local currencies. The franc would receive further support if borrowers were to switch their loans into local currencies at some point in the future, as they would have to unwind their franc short positions. Once upon a time… Over the past decade, a growing number of foreign households and companies borrowed in Swiss francs to finance their local currency investments. Franc-denominated loans became popular in Austria and Eastern Europe owing to Switzerland's lower interest rates compared with their local currency loans. Moreover, the depreciation trend of the Swiss franc between 2003 and 2007 triggered demand for franc loans in Eastern Europe. As long as the franc weakened, demand for franc loans grew. And, for a time, mortgage payments denominated in francs (due to the weakening franc) became progressively less expensive. We suspect that many of these borrowers failed to anticipate the risk of rapid currency movements.

Source: Bloomberg, National authorities, UBS WMR

Risks to foreign-denominated loans Besides risks from exchange rate movements, these loans also carry the risk of rising interest rates in Switzerland, since the loans are normally adjusted to align with the Swiss-franc three-month Libor.

Fig 2. Outstanding Swiss franc loans abroad to non-banks In billions of Swiss franc
550 500 450 400 350 300 250 200 150 100 99 00 01 02 03 04 05 06 07 08 09 Poland EURCHF (rhs) Eurozone Croatia UK Denmark Hungary other 1.70 1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30

Source: Bloomberg, national authorities, UBS WMR

This report has been prepared by UBS AG.

Please see important disclaimers and disclosures that begin on page 5.
Past performance is no indication of future performance. The market prices provided are closing prices on the respective principle stock exchange. This applies to all performance charts and tables in this publication.

UBS Wealth Management Research

6 July 2010

Currency markets

We have tracked this trend since the beginning of 2007, updating developments in the last two years . In this report, we take another look at franc-denominated loans in Europe. Since the start of this year, many foreign borrowers of Swiss franc loans have likely felt very uncomfortable with their loans. While the Swiss National Bank (SNB) blocked any appreciation of the Swiss franc against the euro between March and December of 2009 owing to concerns about deflation in Switzerland, this year, the SNB tolerated a gradual appreciation of the franc from the beginning of the year until mid-2010. Since June 2010, the SNB no longer manages the exchange rate with interventions as it believes deflationary risks in Switzerland have largely disappeared. Since mid-June, the Swiss franc has appreciated sharply against all major currencies, which means that servicing franc-denominated debt has becomes increasingly expensive for foreigners. According to our information, non-Swiss financial institutions either hedge their franc-denominated lending with off-balance-sheet instruments, such as foreign exchange swaps, or refinance them via securitized and nonsecuritized instruments of the Swiss franc money market by issuing francdenominated bonds and interbank deposits. An alpine level of loans The total amount of Swiss franc-denominated loans outstanding outside of Switzerland remained remarkably high at the end of 1Q 2010. These franc-denominated loans peaked in the autumn of 2008 and have declined slightly since then. This dip in volume, in our view, was most likely a consequence of lower demand as the franc grew stronger, as well as the economic crisis, which reduced demand for loans, in both local and foreign currencies in a similar manner. Furthermore, it seems that maturing loans were not renewed anymore in foreign currencies. In some countries, it is now even prohibited to take out low-yielding foreign currency loans. The lending statistics suggest that existing loans are not paid back early. Many borrowers seem to hope that the franc will weaken again before their loans mature, in which case the repayment in their domestic currency would decrease again. The amount of franc loans outstanding has not kept pace with changes to the euro-franc exchange rate. When the franc appreciated for some months, and therefore the borrowing costs rose, no new loans were granted. In contrast, when the franc weakened between 2005 and 2007, the amount of loans outstanding increased rapidly. The total amount of outstanding Swiss franc loans to banks and non-banks rose from CHF 228bn in 1999 to CHF 558bn in the third quarter of 2008, before declining to CHF 488bn in 1Q 2010 (see Fig. 1). To appreciate the magnitude of these figures, consider that the sum of these loans equals around ten times the sum of all Swiss banknotes in circulation (CHF 48 bn in May 2010), and that they are nearly equivalent to Switzerland's nominal GDP of CHF 535bn in 2009. Further, the sum of franc loans abroad is equal to nearly 70% of the outstanding amount of loans in Switzerland (about CHF 723 bn in April 2010). The CHF 488bn loans are roughly double the size of the SNB's
1

Data on CHF loans abroad We examined data from a slew of European central banks on foreign currency-denominated loans to banks and non-banks (households, non-financial corporations, non-bank financial institutions, and governments), within their respective countries. The data comes from the European Central Bank (ECB), and the central banks of the UK, Sweden, Norway, Denmark, Croatia, Hungary, Poland, Slovakia, the Czech Republic, Romania, Latvia, Estonia, Lithuania and Iceland.

Fig 3. Amount of foreign-denominated loans to non-banks as of first quarter 2010
Share of foreign denominated loans of total loans Austria Eurozone Poland Hungary Croatia Romania Lithuania Estonia 20.0% 8.8% 30.9% 66.3% 73.1% 65.4% 73.2% 88.5% share of Swiss franc loans of total loans 13.6% 1.3% 20.0% 34.3% 13.0% 4.9% 0.4% 0.1%

Source: National authorities, UBS WMR

Fig 4. Outstanding Swiss franc loans to nonbanks in the Eurozone In billions of Swiss franc
300 250 200 150 100 50 0 99 00 01 02 03 Eurozone 04 05 06 07 08 09 EURCHF (rhs) 1.70 1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30

Source: Bloomberg, ECB, UBS WMR

Fig 5. Outstanding Swiss franc loans to nonbanks in Austria In billions of Swiss franc
100 90 80 70 60 50 40 30 20 10 0 99 00 01 02 03 Austria 04 05 06 07 08 09 EURCHF (rhs) 1.70 1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30

1 - UBS Wealth management Research (2009): "Currency markets: Swiss-franc loans abroad lose their glow", 25 November 2009 - UBS Wealth management Research (2008): "Investment Theme: Swiss-franc loans abroad offer carry and risk", 7 November 2008 - UBS Wealth management Research (2007): "Forex Guide: Outstanding CHF loans abroad indeed "outstanding"", 28 February 2007

Source: Bloomberg, OeNB, UBS WMR

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UBS Wealth Management Research

6 July 2010

Currency markets

foreign currency reserves. That means there is a large franc short position outstanding, which more than counterbalances the francs that the SNB has created with its current FX interventions. The total amount of outstanding franc loans to non-banks rose at a similar pace, from CHF 117bn in 1999 to CHF 389bn in 3Q 2008 before declining to CHF 345bn in 1Q 2010 (see Fig. 2). There are three ways to describe the amount of franc loans outside of Switzerland: 1) the absolute amount of CHF loans outstanding; 2) CHF loans outstanding as a share of total loans; and 3) CHF loans outstanding as a share of foreign-denominated loans. According to the central bank data, we note:
s Absolute amounts of CHF loans outstanding to non-banks: In the

Fig 6. Outstanding Swiss franc loans to nonbanks in Poland CHF billions
60 50 40 30 20 10 0 04 05 06 Poland 07 08 09 PLNCHF (rhs) 0.55 0.50 0.45 0.40 0.35 0.30 0.25

Source: Bloomberg, NBP, UBS WMR

Eurozone, Austria has the highest amount with about CHF 81bn, followed by Germany (CHF 60bn), France (CHF 30bn) and Luxembourg (CHF 25bn). Outside the euro area, Poland is the leader with about CHF 53bn, followed by Hungary (CHF 36bn), the UK (CHF 23bn), and Croatia (CHF 7bn).
2

Fig 7. Outstanding Swiss franc loans to nonbanks in Hungary CHF billions
50 40 30 20 10 0 03 04 05 Hungary 06 07 08 09 HUFCHF (rhs) 0.75 0.70 0.65 0.60 0.55 0.50 0.45

s CHF loans outstanding to non-banks as a share of total loans: The

highest share can be observed in Hungary (34%), followed by Poland (20%), Austria (14%), and Croatia (13%).
s CHF loans outstanding to non-banks as a share of foreign-

denominated loans: the highest share can be observed in Austria (68%), followed by Poland (65%), Hungary (52%), and Croatia (about 18%).
s Romania and the Baltic states also have large shares of foreign

currency-denominated loans, but they prefer the euro or US dollar (see Fig. 3). Austrians have been borrowing in Swiss francs for more than 15 years (see Fig. 5), while eastern European countries started around 2004. As Hungary, Poland and Croatia have increased their Swiss franc loans aggressively in the last couple of years, the rapid appreciation of the franc and the weakness of their own currencies hurt borrowers in those three countries (see Figs. 6, 7, 8). New borrowers (who requested a CHF loan in 2007 and 2008), are affected more than earlier borrowers, as the latter took out Swiss-franc loans at lower exchange rates (i.e., stronger local currencies, weaker Swiss franc). Loan growth on ice for now Some foreign-currency loans allow the borrower and the bank to switch the loan to another currency. We do not expect holders of franc loans to switch to local currencies as current exchange rates are still at very unattractive levels compared with three years ago. We expect them to stick with the franc as a funding currency in the hope that their local currencies recover versus the franc before their loan matures. But the franc's rapid rise means that servicing franc-denominated debt becomes increasingly more expensive for foreigners, as they have to pay more in local currency terms. It seems that they accept these higher costs. There is some evidence that an increasing number of foreign currency debtors service their monthly payment with a delay.

Source: Bloomberg, MNB, UBS WMR

Fig 8. Outstanding Swiss franc loans to nonbanks in Croatia CHF billions
50 40 30 20 10 0 03 04 05 Croatia
Source: Bloomberg, HNB, UBS WMR

0.25 0.24 0.23 0.22 0.21 0.20 0.19 0.18 06 07 08 HRKCHF (rhs)

2 - The data of Germany, France and Luxembourg is from December 2007. We expect the amount outstanding in these countries to have declined slightly since that time.

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UBS Wealth Management Research

6 July 2010

Currency markets

We expect new franc-denominated loans are unlikely to grow in popularity in the near future owing to negative experiences. Furthermore, political authorities have started to limit or ban foreign currency loans, as they have proven to be a risk to their domestic economies. Banks will also have to double-check the loan-to-asset share. In many cases, the rise of the franc will have lifted the value of the outstanding debt above the value of the asset(s) and made the credit/mortgage shaky. At some point, franc borrowers might realize that the franc might stay strong for longer, which could induce them to switch their loans. While the franc is affected by many factors, should the borrowers of franc loans at some point decide to switch their loans into local currencies, it could support the franc further, as the borrowers have to unwind their franc short positions. We therefore conclude that the large amount of outstanding Swiss franc loans to foreign countries remains a threat for the Swiss economy.

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UBS Wealth Management Research

6 July 2010

Currency markets

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