Nonfinancial companies and other institutions outside of the U.S., excluding banks, may be sitting on as much as $14 trillion in “missing debt” held off their balance sheets through foreign-exchange derivatives, according to research published Sunday by the Bank for International Settlements.
These transactions, which resemble debt but for accounting purposes aren’t classified that way, aren’t new. Rather, researchers from the BIS — a consortium of central banks based in Basel, Switzerland — used global banking data and surveys to estimate the size of this debt for the first time.
The implications for financial stability are unclear because FX swaps are backed by cash collateral and can be used to hedge exposure to currency swings, thus promoting stability. Still, the debt “has to be repaid when due and this can raise risk,” the authors wrote.
According to the paper, published with the BIS’s quarterly update on global financial conditions, non-banks outside the U.S. owed roughly $13 trillion to 14 trillion through foreign-exchange swaps and forwards. That exceeds the nearly $10.7 trillion in dollar debt held on their balance sheets at the end of the first quarter
“Non-banks” include nonfinancial companies, households, governments, and certain financial institutions that aren’t classified as banks and international organizations.
Globally, there are $58 trillion in FX swaps and related exposures, BIS said, which equals about three-quarters of global gross domestic product.
The authors explained that “in an FX swap, two parties exchange two currencies spot and commit to reverse the exchange at some pre-agreed future date and price.” In a forward contract, parties agree to swap currencies at a future date and price. “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,” the paper noted.
This short-term funding is backed by cash and it carries little credit risk. “Even so, strains can arise,” the authors wrote, citing the funding squeeze experienced by European banks during the global financial crisis.
The BIS’s quarterly review didn’t just examine missing debt, it also examined what it called “missing inflation” in the global economy, which has helped spur risk taking and drove up financial asset values in recent months.
The implications are big for stock and bond markets that have moved largely in tandem, with bond yields staying super low while equity markets reached record highs. Whereas faster growth typically implies higher inflation and central bank rate increases, the prospect of significantly tighter monetary policy in the U.S. and other big economies has receded.
“This puts a premium on understanding the ‘missing inflation’, because inflation is the lodestar for central banks,” said BIS chief economist Claudio Borio.
Annual inflation in the U.S., measured by the price index for personal-consumption expenditures, was 1.4% in July. Annual eurozone inflation was 1.5% in August. Both are well below the 2% rate that most big central banks consider optimal. Economists typically cite sluggish wage growth, heightened global competition, low oil prices and the effects of technological changes as explanations for subdued price pressures.
“Despite subdued inflation in advanced economies, the global macro outlook was upbeat. Market commentators label such an environment the Goldilocks scenario — where the economy is ‘not too hot, not too cold, but just right,’” BIS said.
Still, there are risks if bond yields eventually start to rise on the back of firmer global growth, given the sensitivity of the private and public sectors to debt.
Thus, the absence of inflation “is the trillion dollar question that will define the global economy’s path in the years ahead and determine, in all probability, the future of current policy frameworks,” said Mr. Borio.
Source: Dow Jones