The US’s exorbitant privilege has created an exorbitant amount of global dollar borrowing by non-US pensions, companies, insurers and hedge funds.
In its latest quarterly review, out today, the Bank for International Settlements estimates that banks have a total of $52tn of notional obligations in dollar swaps and forwards. About half of that (~$26tn) is made up of credit extended to non-bank clients based outside the US, a group that includes companies and large investors. The non-banks’ exposure has climbed more than 50 per cent in the past six years:
On its face, this doesn’t necessarily contradict the traditional framework for global dollar demand: exporters and importers invoice almost everything in dollars for reasons of history, simplicity, and hegemony, so they need dollars for that purpose.
But look at the counterparty chart from the BIS, found on the far right in the panel below:
It shows that a growing share of global dollar users are financial customers, not banks: Pensions, insurers and hedge funds, along with other institutions that act like banks but don’t report data directly to the BIS.
In other words, large investors have been importing dollars for the sake of importing dollars — probably because of the yield and liquidity found in US markets — and then hedging their currency exposure. This also includes the use of dollar markets as a way to intermediate between less-liquid currencies, according to the BIS.
All in, the dollar has an outsized role in financial markets even compared to import or export markets:
Dollar dominance is striking in this FX market segment, greater than in any other aspect of dollar use. As a vehicle currency, the US dollar is on one side of 88% of outstanding positions — or $85 trillion (Graph 1.A). An investor or bank wanting to do an FX swap from, say, Swiss francs into Polish zloty would swap francs for dollars and then dollars for zloty.
The implications for the global financial system aren’t entirely clear. If an investor offsets their currency exposure well, their notional exposure shouldn’t be a systemic risk. The problem is that they don’t always hedge currency exposure well, and even the smartest hedges can fail during a run or a crisis.
And these hedges are mostly done with off-balance-sheet vehicles such as swaps and forwards. That makes it easy for central banks to be surprised by, say, a massive and violent deleveraging in a country’s pensions.
From the BIS, with our emphasis:
Financial customers dominate non-financial firms in the use of FX swaps/forwards. Non-bank financial institutions (NBFIs), proxied by “other financial institutions” in Graph 1.C, are the biggest users of FX swaps, deploying them to fund and hedge portfolios as well as take positions.
Despite their long-term foreign currency assets, the likes of Dutch pension funds or Japanese life insurers roll over swaps every month or quarter, running a maturity mismatch. For their part, dealers’ non-financial customers such as exporters and importers use FX forwards to hedge trade-related payments and receipts, half of which are dollar-invoiced (Boz et al (2020)). And corporations of all types use longer-term currency swaps to hedge their own foreign currency bond liabilities (McBrady et al (2010), Munro and Wooldridge (2010)).
The BIS’s suggestion? More sunlight and statistics:
The market turmoil during the GFC and in March 2020 highlighted the central role of the US dollar in the financial system. In each episode, disruptions in dollar funding markets led to an extraordinary policy response in the form of central bank swap lines, whereby the Federal Reserve channelled US dollars to key central banks. These episodes point to a need for statistics that track the geography of outstanding short-term dollar payment obligations.
Currently, in order to assess the level and maturity structure of foreign currency gross and net debt, analysts tend to rely on benchmark international statistical collections, which generally cover only the on-balance sheet positions (McGuire (2022)). It is not even clear how many analysts are aware of the existence of the large off-balance sheet obligations. This makes it difficult to anticipate the scale and geography of dollar rollover needs. Off-balance sheet dollar debt may remain out of sight and out of mind, but only until the next time dollar funding liquidity is squeezed. Then, the hidden leverage and maturity mismatch in pension funds’ and insurance companies’ portfolios — generally supposed to be long-only — could pose a policy challenge. And policies to restore the flow of dollars would still be set in a fog.
Interested readers can go to the BIS for the rest of the quarterly report, plus a triennial survey of FX trading and an interesting box on illiquidity in US mortgage markets.
