A new paper published by the Bank for International Settlements (BIS) asks the question, what would balance sheets look like if the borrowing through FX swaps and forwards were recorded on-balance sheet, as the functionally equivalent repo debt is?
The authors of the report, FX Swaps and Forwards: Missing Global Debt? observe that these products “create debt-like obligations” and state that non-banks outside the US owe large sums of dollars off-balance sheet through these instruments. They add that the total is of a size similar to, and probably exceeding, the $10.7 trillion of on-balance sheet dollar debt.
The calculation of this debt comes from BIS statistics on outstanding derivatives contracts, and the authors note, “The debt remains obscured from view. Accounting conventions leave it mostly off-balance sheet, as a derivative, even though it is in effect a secured loan with principal to be repaid in full at maturity. Only footnotes to the accounts report it.”
The paper does observe, as could be argued, that an FX swap has two currencies and therefore a large dollar debt could be balanced by, for example, large balances in euros and yen. However it also states, “Much of the missing dollar debt is likely to be hedging FX exposures, which, in principle, supports financial stability. Even so, rolling short-term hedges of long-term assets can generate or amplify funding and liquidity problems during times of stress.”
When looking at the accounting treatment, the authors ask the rhetorical question, why such a difference? One reason, the explain, is that forwards and swaps are treated as derivatives, so that only the net value is recorded at fair value, while repurchase transactions are not. Since the value of the forward claim exchanged at inception is the same, the fair value of the contract is zero and it changes only with variations in exchange rates.
“Yet, unlike with most derivatives, the full notional amount, not just a net amount as in a contract for difference, is exchanged at maturity,” the authors state. “That is, the notional amounts are not purely used as reference for the income streams to be exchanged, such as in interest rate derivatives. Another reason is the definition of control, which for cash requires control over the cash itself (e.g. a demand deposit) but for a security just the right to the corresponding cash flows. This determines what is recognised and not recognised on the balance sheet.”
According to the latest BIS Semi-Annual report on Derivatives Outstanding, at end December 2016 (the latest data available) the outstanding amounts of FX swaps/forwards and currency swaps stood at $58 trillion. For perspective, the authors note this figure approaches that of world GDP ($75 trillion), exceeds that of global portfolio stocks ($44 trillion) or international bank claims ($32 trillion), and is almost triple the value of global trade ($21 trillion).
More than three-quarters of those outstanding contracts were at the short end, under one year (and in reality probably much shorter than that), but the total amount has more than quadrupled since the early years of the century.
The reason the authors focus on the dollar element of these contracts is, as they note, its share of FX forward and swaps markets is in excess of 90%. Indeed they add that even in currencies like the Scandinavian and eastern European currencies that are largely traded against the euro in spot markets, the dollar is the dominant currency in the forwards.
Focusing on the non-financial sector, the authors note that the predominant use of FX swaps and forwards is for hedging purposes, thus, they argue, “one can relate non-financial FX swaps/forwards and currency swaps, in an admittedly stylised fashion, to international trade and bond issuance, respectively”.
If firms use $5.1 trillion of short-term FX forwards to hedge global trade of $21 trillion, then the ratio implies that importers and exporters hedge at most three months’ trade. Similarly, if firms and governments use $2.4 trillion of currency swaps to hedge $4.8 trillion of international bonds, then they hedge half or less.
Looking at non-bank financial institutions, the paper notes “broad brush”, their FX swaps/forwards holdings can be compared with global cross-border securities holdings. If $18.9 trillion of FX forwards hedge a $44 trillion portfolio, then institutional investors would hedge as much as 40%.
The $6.6 trillion in currency swaps that non-bank financial firms have contracted stand at almost 80% of their outstanding international debt securities, the paper continues. Regression analysis supports such a high hedge ratio, however, given the activity of hedge funds in the currency swap market, the 80% should be regarded as an upper bound on non-bank financial firms’ hedging.
Turning to banks, the authors reveal that non-US banks’ net dollar lending through the FX swap market falls short of their net borrowing, with the gap widening over time. More specifically, dollar borrowing against other major currencies, like the yen and the euro, exceeds dollar lending against secondary and emerging market currencies.
“Who, then, lends dollars to non-US banks via the FX swap market?” the authors ask. Four candidates are: US banks, central banks, European agencies and supranational organisations, and private non-banks. ‘All of these appear to provide some funding, with US banks and central banks together closing about half the gap,” the paper states.
As regards the first candidate, US banks naturally lend dollars via FX swaps: $150 billion in the latest data. This figure combines positions from offices outside and inside the US. BIS data offer a fairly complete picture of US banks’ positions outside the country, the authors state, adding they point to $33 billion in net lending at end-Q1 2017, down from more than $400 billion in 2011.
Second, they continue, central banks lend dollars via FX swaps against either their own currency or third currencies. Against their own currency, some Asian central banks provide about $200 billion in swaps as they manage the domestic liquidity consequences of FX reserve accumulation. They first buy dollars spot (increase their FX reserves) and then drain domestic liquidity by swapping (lending) the dollars for (against) domestic currency. On net, however, central banks’ dollar supply against their own currencies is close to zero, since other central banks are actually borrowing dollars via FX swaps. They do so in order to finance their accumulation of FX reserves without incurring currency risk (borrowed reserves).
Against foreign currencies, some central banks lend dollars via swaps in the management of their FX reserve portfolio. For instance, the Reserve Bank of Australia swaps US dollars for yen, the paper states, adding, “We estimate that such operations by reserve managers sum to at least $300 billion.”
Regarding the third possible answer, the authors note that European supranationals and agencies have opportunistically borrowed dollars to swap into euros to lower their funding costs. While their operations mostly require euros, they have done so to take advantage of the breakdown in covered interest parity. “Five European supranationals and agencies together had over $400 billion in dollar debt in June 2017,” they state. “We estimate that these alone have provided $300 billion in swaps against the euro.”
Finally, the authors point out that non-bank private sector entities can provide hundreds of billions of dollars. “Like US banks, US-based asset managers are obvious candidates,” they say. “In June 2014, the then largest US bond fund, PIMCO’s Total Return Fund, reported $101 billion in currency forwards, no less than 45% of its net assets. Since the overall US holdings of foreign currency bonds were $600 billion at end-2015, a 50% hedge ratio would extrapolate to $300 billion. On the equity side, US investors’ hedge ratios are thought to be 40–50% for advanced economy equities. “In addition, US firms that hold cash in offshore affiliates to avoid US corporate tax on repatriated earnings could be sizeable lenders as well,” they add.
The BIS also publishes Global Liquidity Indices (GLIs), which include estimates of dollar debt held outside the US by non-banks.
These cash market obligations, both bank loans and bonds, as noted earlier, totalled $10.7 trillion at end-March 2017. “What would be the corresponding additional debt borrowed through the FX derivatives markets?” the authors ask. “The order of magnitude is similar: the missing debt amounts to some $13–14 trillion.
“But the implications for financial stability are quite subtle and require an assessment of both currency and maturity mismatches,” they warn.
Obtaining such estimates requires a series of steps and assumptions, the authors accept, explaining that first, the BIS OTC derivatives statistics report total dollar-denominated forwards and swaps outstanding vis-à-vis customers (their proxy for non-banks) of $28 trillion. Second, they say they need to make an assumption about the direction of non-banks’ positions. “We could assume that the amount of dollars lent and borrowed through derivatives by customers is matched,” the paper states. “This would require reporting dealers, as a sector, to be also balanced: data slippage aside, customers and dealers make up the whole market. If so, to obtain the total amount of non-banks’ gross dollar borrowing through FX forwards, one would divide by two. This gives $14 trillion.
The authors point out, however, that, as was suggested elsewhere in the paper, banks as a whole use the market for net dollar borrowing. “If so, one could subtract that amount from the total before dividing,” the say. “Even then, an upper estimate of the banks’ net position would be, say, $2 trillion. This would imply (after dividing the remaining amount by two) a lower amount of non-bank dollar borrowing of $13 trillion.
“Finally, we need to estimate the fraction of that debt held by non-US residents,” they continue. “If US residents use the bulk of their derivatives for hedging purposes, the amount would be small.”
Just as for the case of the $10.7 trillion worth of on-balance sheet debt, the authors observe that the additional dollar debt contracted through FX derivatives is to some extent supported by dollar revenues and/or assets, i.e. currency-matched. “The previous analysis suggests that the whole amount of that debt could be rationalised by hedging activity, be it trade or asset holdings,” they say. “It also indicates that a portion of dollar off-balance sheet lending, estimated at as much as $3 trillion, may hedge the on-balance sheet dollar bond debt included in the existing GLI estimate. “That ratio has declined as emerging market bond issuers have gained prominence,” they continue. “Such hedging can support financial stability, especially if maturities are matched. At the same time, the reassurance cannot be complete. Experience shows that FX derivatives can also be used to take open positions, including in the form of carry trades. And off-balance sheet debt can cause or amplify strains, especially in the case of FX options (which are beyond the scope of this analysis). The available statistics do not allow us to identify the extent of speculative use.”
Notwithstanding the fact that a large amount of the debt is currency matched, the authors argue that it has to be repaid when due “and this can raise risk”. They accept that such risk is mitigated by the other currency received at maturity and point out out that most maturing dollar forwards are probably repaid by a new swap of the currency received for the needed dollars. This new swap rolls the forward over, borrowing dollars to repay dollars.
“Even so, strains can arise,” they state. “In particular, the short maturity of most FX swaps and forwards can create big maturity mismatches and hence generate large liquidity demands, especially during times of stress. Most spectacular was the funding squeeze suffered by many European banks during the GFC. Indeed, in response, the Swedish bank supervisor has applied liquidity requirements separately to banks’ dollar and euro positions.
“But non-banks may also face similar problems when they run such mismatches, both on- and off-balance sheet,” they continue. “During the GFC, central banks extraordinarily extended dollar credit to non-banks in Brazil ($10 billion programme) and Russia ($50 billion). Moreover, even sound institutional investors may face difficulties. If they have trouble rolling over their hedges because of problems among dealers, they could be forced into fire sales.”