Evans-Pritchard - BIS discovers $14 trillion of dollar debt offshore, hidden in 'footnotes'

by Ambrose Evans-Pritchard
17 September, 2017

The world’s top financial watchdog has uncovered $14 trillion of global dollar debt hidden in derivatives and swap contracts, a startling sum that doubles the underlying levels of offshore dollar credit in the international system.

The scale of this lending greatly increases the risk of a future funding crisis if inflation ever forces the US Federal Reserve to tighten hard, draining worldwide liquidity and potentially triggering a dollar surge.

A forensic study by the Bank for International Settlements says enormous liabilities have accrued through FX swaps, currency swaps, and ‘forwards’. The data is tucked away in the “footnotes” of bank reports. “Contracts worth tens of trillions of dollars stand open and trillions change hands daily. Yet one cannot find these amounts on balance sheets. This debt is, in effect, missing,” said the BIS analysis, written by team under chief economist Claudio Borio.

“These transactions are functionally equivalent to borrowing and lending in the cash market. Yet the corresponding debt is not shown on the balance sheet and thus remains obscured,” they wrote in the BIS’s quarterly report.

A breath-taking gap in global accounting rules mean that the debt is booked as a notional derivative, “even though it is in effect a secured loan with principal to be repaid in full at maturity.”

The hidden lending comes on top of $10.7 trillion of recorded offshore dollar debt outside US jurisdiction. It pushes the combined total to $25 trillion or a third of global GDP.  While these contracts serve as a lubricant and hedging device for world commerce, they can be plagued by currency and maturity mismatches.

The dollar swaps serve as a ‘money market’ for global finance. Investors often take out short-term contracts that must be rolled over every three months.  The great majority have maturities of less than a year. Much of the money is used to make long-term investments in illiquid assets, the time-honoured cause of financial of financial blow-ups. “Even sound institutional investors may face difficulties. If they have trouble rolling over their hedges, they could be forced into fire sales,” said the Swiss-based watchdog.

While the BIS is careful to talk in broad terms, it is known that Chinese developers have borrowed heavily in US dollars through the FX swaps market. They do so because rates are lower and to dodge credit curbs. If funding suddenly dries up, Chinese regulators may be reluctant to bail them out for political reasons - until the situation is very serious.

“A defining question for the global economy is how vulnerable balance sheets may be to higher interest rates,” said Mr Borio, the High Priest of the global banking fraternity.

Signs of excess are visible everywhere. “Corporate debt is now considerably higher than it was pre-crisis.  Leverage indicators have reached levels reminiscent of those that prevailed during previous corporate credit booms. A growing share of firms face interest expenses exceeding earnings before interest and taxes,” said the report.

The BIS warned that margin debt used on equity markets exceeds the dotcom extreme in 2000. So-called ‘leveraged loans’ have surged to a record $1 trillion, and the share with risky ‘covenant-lite’ terms have jumped to 75pc. Everything looks fine so long as low bond yields underpin the asset edifice, but they may not stay low. “Equity markets continue to be vulnerable to the risk of a snapback in bond markets,“ it said.

The structure is deeply unhealthy. Central bankers dare not lift rates despite economic recovery because of what they might detonate. “There is a certain circularity that points to the risk of a debt trap,” said Mr Borio.

The Achilles Heel is global dollar debt. It was a seizure of the offshore dollar capital markets in late 2008 that turned the Lehman and AIG bankruptcies into a global event, and came close to bringing down the European banking system.  “The meltdown in dollar-denominated structured products caused funding markets to seize up and banks to scramble for dollars. Markets calmed only after coordinated central bank swap lines to supply dollars,” said the BIS.

The Fed effectively saved Europe from disaster. It is an open question whether the US Treasury would authorize such a rescue under the Trump Administration.

The Sword of Damocles still hangs precariously a decade later. Global dependence on dollar liquidity has since become even more extreme. Over 90pc of all FX swaps and forwards worldwide today are in US currency. The dollar is even used within Europe for most swaps involving the Polish zloty or the Swedish krona for example, a pattern that would probably astonish European politicians. “The dollar reigns supreme,” said the BIS.

What is odd is that Asian central banks and European multilateral bodies are huge players in this trade, effectively aiding and abetting a dangerous game.

The message from a string of BIS reports is that the US dollar is both the barometer and agent of global risk appetite and credit leverage. Episodes of dollar weakness - such as this year - flush the world with liquidity and nourish asset booms. When the dollar strengthens, it becomes a headwind for stock markets and credit.

If the dollar spikes violently, it sets off global tremors and a credit squeeze in emerging markets. This is what could happen again if President Trump’s tax reform plans lead to a big fiscal expansion and a repatriation of trillions of US corporate cash held overseas.

Currency analysts say it would be an emerging market bloodbath. While the ‘fragile five’ - India, South Africa, Indonesia, Turkey, Brazil - have mostly cut their current account deficits and are in better shape than during the ‘taper tantrum’ of 2013, the problem has rotated to oil producers. China’s corporate debt has soared to vertiginous levels.   Recorded dollar debt in emerging markets has doubled to $3.4 trillion in a decade, without including the hidden swaps. Local currency borrowing has risen by leaps and bounds. They are no longer low-debt economies.

The BIS credit gap indicator of banking risk is flashing a red alert for Hong Kong, reaching 35pc of GDP. While it has dropped to 22.1pc in China, the country is still in the danger zone. Any sustained reading above 30 is a warning signal for a banking crisis three years later.

Canada is also vulnerable at 11.3. Turkey (9.7) and Thailand (9) are on the edge. Most would be in trouble if global borrowing rose by 250 basis points.

The UK is well-behaved on the credit gap metric. That is small comfort. There will be nowhere to hide if the world ever faces a dollar ‘margin call’.