currency

Seventy trillion dollars is a lot of money. It is nearly three times the size of the U.S. GDP, and approaches total global GDP (around $100 trillion). That is the amount of funds that are missing from normally reported financial statistics, according to a December, 2022 report from the Bank for International Settlements. That report caused a bit of a flurry in financial circles.

It’s not that this money has been stolen, it’s just that it is not publicly known exactly where it is, i.e., how much money that which parties owe to whom. Here is the Abstract of this paper:

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. NonUS 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.

Much of this money is in the form of currency swaps, especially foreign exchange (FX) swaps. Even though the U.S. economy no longer dominates the whole world, the U.S. dollar remains the premier basis for international trade and even more for foreign exchange:

As a vehicle currency, the US dollar is on one side of 88% of outstanding positions – or $85 trillion. 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.

Who cares? Well, the incessant demand for dollars periodically leads to a dollar funding squeeze in international trade, which in turn reverberates into world GDP.

Currency Swaps as Lending Events

In many cases these currency swaps effectively amount to short-term lending /borrowing (of dollars). Much of the financial world is utterly dependent on smoothly flowing short-term funding to cover longer term debt or investments. Borrowing short-term (at usually lower interest rates) and investing or lending out longer-term (at higher rates) is how many institutions and funds exist. For instance, depositors at banks effectively lend their deposits to the bank (short-term), in return for some pitiful little interest on their checking or savings accounts, while the banks turn around and make say 5 year or 30-year loans to businesses or home-buyers. Banks earn profits on the spread between the interest rates they receive on the funds they loan out, and the typically lower rates on the short term funds they “borrow” from their depositors.

This “mismatch” between the maturities of borrowed funds (especially dollars) and invested funds can cause a complete melt-down of the financial system if holders of dollars stop being willing to lend them out, or to lend them out at less than ruinous interest rates:

The very short maturity of the typical FX swap/forward creates potential for liquidity squeezes. Almost four fifths of outstanding amounts at end-June 2022 in Graph 1.B matured in less than one year. Data from the April 2022 Triennial Survey show not only that instruments maturing within a week accounted for some 70% of FX swaps turnover, but also that those maturing overnight accounted for more than 30%. When dollar lenders step back from the FX swap market, the squeeze follows immediately.

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. And corporations of all types use longer-term currency swaps to hedge their own foreign currency bond liabilities .

It is really bad if pension funds or insurance companies get starved of needed ongoing funding. Central banks, especially the dollar-rich Fed, have had to repeatedly jump in and spray dollar liquidity in all directions to mitigate these “dollar squeezes”. The BIS authors’ main concern is that these big public policy decisions are currently made in absence of data on what the actual needs and issues are. Hence, “Policy responses to such squeezes include central bank swap lines that are set in a fog.”

This all is part of the murky “Eurodollar” universe of dollar-denominated bank deposits circulating outside the U.S. (more on this some other time). Investing adviser Jeffery Snider offers the “Eurodollar University” on podcasts and on YouTube, in which he explores the many dimensions of the Eurodollar scene. He likens the Eurodollar system to a black hole: we cannot observe it directly, but we can estimate its size by its effects.

In his YouTube talk on this BIS paper, among other things Snider notes that this short-term lending associated with currency swaps functions much like repo borrowing, except the currency swaps (unlike repo) do not appear on bank or other balance sheets as assets/liabilities. That is part of the attraction of these swaps, since they are effectively invisible to regulators and are not constrained by e.g., capital requirements.

What the Fed does in a dollar squeeze is largely lend dollars to large dealer banks. But unless those other banks then lend those dollars out into the private marketplace of manufacturers and shippers and pension funds, having trillions of dollars in central bank reserves has little effect. It is not the case that “the Fed floods the world with dollars” — actually, mainstream banks get those dollars, and then lend out at high rates to the dollar-starved rest of financial world, where they can actually do something.

The result, according to Snider, is that the Eurodollar is the only functional reserve currency in existence. This is the real, effective banking system (not “reserves” sitting on some bank’s balance sheet), even though the current accounting system doesn’t show it.

Economics involves human beings making decisions. Where there are humans, drama is never absent. Hence, somewhere in the broader financial sphere, there is always some drama. The chart below displays gyrations in the exchange rate of the Turkish lira which may be fairly characterized as “dramatic”. This chart shows the lira-per-dollar exchange rate over the past six months; a higher number here means lower lira valuation.

Foreign Exchange Market Prices, Turkish Lira per Dollar. Source: TradingView.com

What is going on here? Why the spike up in November/December, followed by an even more sudden drop?

As usual, loss of value in foreign exchange goes hand in hand with domestic inflation. Inflation within Turkey for the month of December was reported to 36% on an annualized basis. Now, an orthodox economic response to runaway inflation includes raising interest rates. Higher interest rates tend to make a currency more valuable. Higher interest rates encourage people to hold onto their currency, since they are rewarded by interest on their savings. Conversely, low interest rates, especially when coupled with inflation, motivates people to spend down their money before it loses more value. In the case of emerging market countries like Turkey, high inflation/low interest drives people to exchange their local currency for more stable foreign currencies, like dollars or euros (or crypto stablecoins like Tether).

But Turkey is Turkey, and Turkey is run by the authoritarian President Erdogan. He has economic views which might most charitably characterized as “heterodox”. Erdogan claims that high interest rates actually cause inflation. His views may be influenced by the prohibition on charging interest in classic Islamic practice. The Turkish president has stated, “My belief is that interest rates are the mother of all evils. Interest rates are the cause of inflation. Inflation is a result, not a cause. We need to push down interest rates.” President Erdogan has sacked numerous treasury officials who disagreed with him, and pressured the central bank to implement four interest rates cuts in the last four months of 2021.

It seems he hopes to stimulate enough internal growth to paper over any other problems. I think there could be some merit to that notion, but the current inflation level is toxically high. Lower- and middle-class Turks find it hard to purchase necessities.

Lowering the value of your currency to make your exports more attractive has been practiced successfully by various Asian nations, but Turkey is too exposed to foreign exchange to weather such a huge drop in the value of the lira. A large part of Turkey’s recent economic growth has been funded by foreign investors, and that may dry up because of the currency instability. Turkey is dependent on imports for many essentials, including all of its energy needs, so imports have become much more expensive for Turks as their currency depreciates. Furthermore, because of the fluctuating value of the local currency, many loans are denominated in dollars or euros. This makes it burdensome for borrowers to keep up payments of interest and principal, when these foreign currencies have become more expensive.

Modern currencies have essentially no intrinsic value. Money is a big confidence game. A shopkeeper will take my dollar bill in exchange for some candy, because he is confident that some other party will in turn accept that dollar bill in exchange for something else of value. If confidence in a currency collapses, so does its exchange value.

Foreign creditors and domestic Turkish consumers were becoming more and more nervous about the prospects for the lira in late 2021, as inflation was fueling further inflationary expectation. It crashed to a record high exchange rate of 13.44 against the dollar on November 23 after the Turkish leader insisted that rate cuts would continue.

Things really started getting out of control in mid-December. Turks frantically ditched their currency in exchange for euros and dollars, which led to further devaluation of the lira. On December 21^st, however, the Turkish government unleashed an innovative initiative. They offered to backstop the value of the lira deposits of Turkish residents, as long as those deposits were held in lira for a certain period of time. Besides offering interest on the deposits, the offer was to compensate depositors for any loss in value against the dollar. The intent was to motivate residents to keep their lira as lira.

Turkey’s new Finance Minister Nureddin Nebati has no real finance background; his main qualification for office appears to be a willingness to do what his boss wants. When Nebati was asked to give details of this initiative, he reportedly answered thus: “”I won’t give a number now. Can you look into my eyes? What do you see?… The economy is the sparkle in the eyes.” Hmm.

President Erdogan has said he is protecting the country’s economy from attacks by “foreign financial tools that can disrupt the financial system.” Western economists are not impressed. Market strategist Timothy Ash commented, “ More complete and utter rubbish from Erdogan…Foreign institutional investors don’t want to invest in Turkey because of the absolutely crazy monetary policy settings imposed by Erdogan.”

At any rate, this unusual measure, combined with old-fashioned central bank intervention (the Turkish central bank is believed to have used some 10 billion dollars’ worth of its foreign reserves to buy lira), seemed to stem the immediate panic. Within a day, the exchange rate thudded down from about 18 to about 13, which is roughly the level today.

It has been pointed out that it simply is not feasible for the government to backstop all relevant bank deposits against a huge currency depreciation; the Turkish government and central bank would burn through all their foreign reserves, and have to resort to printing ever more worthless lira. However, sometimes the mere promise of such a guarantee (whether or not it is practical) is enough to restore some measure of confidence, which in turn means that the currency will not collapse and thus the resources of the central bank will not be put to the test. As we said, confidence is what it is all about. We will see how this plays out.