Dollar debt in FX swaps and forwards: Time Bomb in Global Finance

In December last year, BIS had come out with a report that raised concerns on how dollar positions on FX markets have risen over the years and poses a concern.

FX swaps, forwards and currency swaps create forward dollar payment obligations that do not appear on balance sheets and are missing in standard debt statistics. Non-banks outside the United States owe as much as $25 trillion in such missing debt, up from $17 trillion in 2016. Non-US banks owe upwards of $35 trillion. Much of this debt is very short-term and the resulting rollover needs make for dollar funding squeezes. Policy responses to such squeezes include central bank swap lines that are set in a fog, with little information about the geographic distribution of the missing debt.

Rob Johnson of Institute of New Economic Thinking discusses the implications of the report:

Paul Jay

So, Rob, all this stuff is so complex that people not involved, and I suspect a lot of this complexity is deliberate, so people not involved don’t understand it. If it wasn’t for a few articles in the Financial Press, nobody would even know of this BIS report. How dangerous is this warning?

Robert Johnson

Well, a number of things come to mind. First of all, I want to encourage people to get better acquainted with the Bank for International Settlements. The various people there, Bob McCauley, Hyun Shin, and others, are at a multilateral institution in a time of globalization, and they are studying the fault lines and flaws in the system. Whether it be in the old days, how the Asian companies all borrowed dollars and then brought the money into renminbis so they could have a U.S.-China crisis, as they had in 2015, or what we might call swaps and forwards mismatch, they’re talking about now. They look for the vulnerable, the weak links, or the fault lines in the system.

Paul Jay

How dangerous is this warning?

Robert Johnson

Well, I think the scale that we’re talking about, the $39 trillion, etc. tells you that if something slips, like if you step on the banana peel– what they talk about in their report is the central banks will then all have to come in and open the spigots. In other words, if there’s a dollar shortage and it creates a frenzy, they’re going to have to supply the dollars to put out the fire. What that comes down to is what I have referred to in the work I’ve done on finance as the ‘mother of all moral hazards’. If you know the central bank can see the big institutions creating something that’s dangerous for the whole world, the central bank has no choice– what we might call an organ of public policy– but to try to put out the fire. But if you know they’ll put out the fire, you may take more risk knowing you’re going to get underpinned. What we need is a system where they’re there to rescue, but they also have the capacity to evaluate these institutions, have proper reporting of their positions, and which you might call impose prior restraint.

Hmm…finance will always find ways to bring home a new crisis in old bottle