The Sword of Damocles still hangs precariously a decade later. -Ambrose Evans-Pritchard
The Bank for International Settlements (BIS) has uncovered a $14 trillion dollar-denominated debt bubble hidden in derivatives and swap contracts – a shocking sum that doubles the amount of offshore USD credit in the international system.
While the debt serves as a lubricant and a hedging mechanism for global commerce, its mere existence greatly adds to the risk of a global debt crisis if the the Dollar surges via Fed tightening or extreme risk-off trading.
A forensic study by the BIS concludes that enormous liabilities have accumulated through FX swaps, currency swaps, and “forwards” – all hidden 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. The debt is, in effect, missing,” reports a BIS investigative team led by chief economist Claudio Borio.
“A defining question for the global economy is how vulnerable balance sheets may be to higher interest rates,” said Borio, adding “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.”
Booked as a derivative, acts like a debt
Due to global accounting rules, the trillions in new-found debt has been booked as a notional derivative – “even though it is in effect a secured loan with principal to be repaid in full at maturity,” says the BIS.
Often used for dangerous illiquid investments
Via Financial Post
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 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.
Signs of strain
The BIS goes on to warn of the massive excesses in debt across the spectrum. “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 also warns that margin debt on equities exceeds the dotcom extreme in 2000, and so-called ‘leveraged loans’ have surged to a record $1 trillion.
So far, the global financial system has been able to service these derivative-based debts thanks to low interest rates – however once rates begin to rise, the entire house of cards will be subject to increasing levels of risk.
“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 Borio.”
FP reports “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.”
Will the Fed come to the rescue again?
After former Fed chairman Ben Bernanke and Treasury Secretary Hank Paulson held a gun to congress’ head in September of 2008, kicking off Trillions of bailouts and a massive revolving liquidity complex – the U.S. Fed effectively saved the global banking system from disaster. The question now is whether or not they’ll do it again. One would assume that team Yellen / Mnuchen / Cohn could easily convince President Trump to turn on the spigot.
Emerging markets screwed
If the dollar spikes violently, for whatever reason – be it interest rates rising or global risk-off trading and a flight to bonds, the emerging markets stand to suffer the most from a strong dollar.
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 US$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 35 per cent of GDP. While it has dropped to 22.1 per cent 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.
So – enjoy historically low interest rates while they last. Lord knows central banks around the globe will be keeping them as low and liquidity-generating as long as they possibly can.If you enjoy the content at iBankCoin, please follow us on Twitter