8 minute read
*Author Update: I added a chart to reflect December 2, 2024.
In 1971, the U.S. Treasury Secretary – John Connally - once shocked European counterparts when he said1, “The dollar is our currency, but it’s your problem.”
John Connally’s 1971 remark remains relevant today, as a rising dollar continues to pose challenges for both advanced and emerging economies. If he were around today (more than 50 years later), he might say something similar about the current situation: it’s still our currency, and it’s still the world’s problem.
The Federal Reserve’s rapid interest rate hikes, the fastest in 30 years, might benefit the U.S. in its fight against inflation. However, this approach comes at a substantial cost to the global economy, causing a strong dollar and creating a “dollar shortage.”
- I wrote to you a few weeks ago about the global dollar shortage and how the rest of the world is dealing with that pain (read here if you missed it2). But in short, the strong dollar is acting like a wrecking ball on the global economy. It’s putting pressure on every other currency, causing import prices to rise, and worst of all – causing dollar-debt servicing costs to soar (bad news for the massive amount of dollar-backed debt that’s held by foreigners).
This is why I believe - contrary to the mainstream – the U.S. dollar won’t be replaced as the world’s reserve currency anytime soon. And in fact, may become more entrenched in the years to come.
Said another way, the U.S. dollar is still the prettiest mare in the slaughterhouse - meaning that among all the paper currencies out there, it remains the most desirable option (even though they’re all looking bad).
Let me show you why. . .
What Is the Hidden Dollar Debt Crisis?
What if I told you there are tens of trillions (estimated at around $80 trillion) in hidden, off-balance sheet dollar debts3 held around the world?
Pretty unsettling, right?
Now, you may be wondering, “What the hell is a hidden debt?”
In short, I’m talking about FX swaps, forward contracts, and currency swaps (all forms of debt) that create future dollar payment obligations that aren’t recorded on balance sheets and stay absent from standard debt statistics.
- This means that banks, corporations, or other non-bank entities could have many trillions in these obligations, without them ever appearing on their balance sheets.
For instance, according to late-2022 research from the Bank of International Settlement4 (known as the BIS, the central bank to rule them all), non-banks - such as corporations, mortgage lenders, investment banks, pension funds, insurance firms, hedge funds, etc. - outside the U.S. owe up to $26 trillion in hidden debt, a figure that’s increased from $17 since 2016. This amount is double their on-balance sheet debt.
Meanwhile, non-U.S. banks – such as foreign banks that operate in the U.S. like HSBC, UBS AG, Bank of Austria, Royal Bank of Canada, etc. - owe about $39 trillion in dollar debt from these instruments, more than double their on-balance sheet dollar debt and over ten times (1,000%) their capital.
To put this into perspective the estimated $80 trillion-plus "hidden" debt surpasses the combined stocks of dollar Treasury bills, repo, and commercial paper, according to the BIS paper.
It's a scary thought when realizing major global institutions - such as insurance firms, big banks, pension funds, etc are sitting on these.
That's why I believe this enormous amount of hidden debt via FX swaps and the like are potential Weapons of Mass Financial Destruction (WMFDs) if they’re forced to unwind quickly and losses mount.
Keep in mind that these financial instruments are complicated (possibly made that way so people won’t look into them). But it’s worthwhile to understand them since they play a huge role in global markets
Here’s an easy way to understand it. . .
Breaking It Down: How FX Swaps Work
Imagine two friends, Sam and Alex, each with library cards. Sam has checked out a novel (let's say Mexican Pesos), and Alex has checked out a cookbook (Japanese Yen). They agree to swap books for a week. During that week, Sam reads the cookbook (uses the yen), and Alex reads the novel (uses the pesos). At the end of the week, they return the books to each other so they can return them to the library. They might also exchange notes or recipes (like interest payments) they found useful in the books. This way, both friends enjoy new content without permanently giving up their original books.
In the financial world, a currency swap works similarly. Banks and institutions temporarily exchange currencies (let’s say the euro) to manage risks and get the money they need (U.S. dollars), agreeing to swap them back later without affecting their official records.
- Why do this? Because banks or corporations use currency swaps or FX swaps to manage currency risk, secure better borrowing rates, or optimize their cash flow in different currencies. For example, a U.S. company with significant operations in Europe might use an FX swap to exchange dollars for euros to pay their European suppliers, hedging against exchange rate fluctuations and aligning their currency exposure with their operational/payroll needs.
So, What’s the Problem with All This Hidden Debt?
Well, if a good amount of these short-term debts all come due or go the other way, it’s like everyone suddenly needing to return their borrowed library books at the same time, causing a panic of friends trying to get their original book back and rush to the library (in this case, the dollar market trying to get dollars) before they get penalized or banned from checking out new books.
- And making matters worse, what if Alex lent the novel he borrowed from Sam to another friend? And what if Sam did the same thing with the cookbook? And on and on? It gets complicated and messy quickly from all these “hidden” aspects.
Thus, all this sudden demand for dollars (from everyone rushing to get them) can send its value surging, which will only amplify the problem (making the dollar stronger and stronger, reinforcing the FX swap losses, while putting pressure on global currencies, economies, commodities, etc.).
Why?
Because everything is still anchored to the U.S. dollar.
Why Central Banks Might Struggle to Respond
Now, if this happens, central banks can step in to help with “swap lines” (aka temporarily exchanging foreign currencies to provide the needed U.S. dollars). But remember, most of these central banks only have a finite limit of dollars.
- Meaning the U.S. Treasury and Fed are the only ones that can actually create dollars. The rest depend on borrowing more dollars or exporting more goods than importing (to gain dollars).
This is why they depend on the Fed to supply them with dollars during a crisis (like we saw in 2020 when the Fed had to pour money5 into central banks around the world amid the dollar shortage).
But does the Fed want to inject U.S. dollars – risking inflation at home – just to aid foreign nations? Those are the kind of trade-offs need to be accounted for when they see headlines like “U.S. Fed Bails Out XYZ Country With Swap Lines”.
So, for example, if Swiss pension funds need $5 trillion to settle the sudden unwinding of FX swaps and don’t have the $5 trillion available, they can borrow from the Swiss National Bank (Switzerland’s central bank). But if the Swiss central bank only has $1 trillion, then that’s a big problem.
Another big issue is that these “solutions” often lack transparency. And it’s unclear exactly where all the hidden debt is located, making it hard to address the severity of the potential problems.
Put simply, there are way too many dollar loans outstanding and not enough actual dollars to service them all. Meanwhile, most are being hidden (parked off balance sheets) so we can’t gauge who is owed what until it’s painfully clear.
Talk about fragile by design, right?
So Why Does This Matter?
All this ties back to the global dollar shortage.
Put simply, on a global scale, there’s a massive amount of dollar debt that requires constant dollar inflows for repayment.
This is why it’s called the "dollar shortage" – debtors never have enough dollars, which likely keeps the dollar "stronger" in the years to come due to high demand.
Meanwhile, the Fed’s higher interest rate policy acts like a suction pump on global liquidity, pulling dollars in from around the world. This functions like a wrecking ball on the global economy. Foreign currencies against the dollar have been battered, making it more expensive to convert to dollars later (see chart below of major currencies relative to the dollar over the last 15 years).
Key Takeaways
The global dollar debt crisis reveals a fragile system “anchored to the dollar.”
Without proactive measures, hidden debt risks could spiral into broader financial instability.
Connally’s words echo louder than ever: It’s our dollar, and it’s still your problem.
Sources:
- The dollar is our currency, but it’s your problem - EIU Corporate Network
- The Big Drought: A Global Dollar Shortage Is An Overhang On The Global Economy | Dunham
- FX swap debt a $80 trillion 'blind spot' BIS says | Reuters
- Dollar debt in FX swaps and forwards: huge, missing and growing (bis.org)
- Swap lines curbed global dollar shortages, appreciation during COVID-19 crisis - Dallasfed.org
Disclosures:
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