The Perils of Foreign Currency Debt Revisited

I have learnt to expect the unexpected in global funding and investment markets. I read a Bloomberg story on 29 June 2018 titled “China is said to Weigh Banning Short-Term Dollar Bond Sales”. It gave me an immediate sinking feeling. I thought “Oh dear, what were they thinking?”

USD Libor 1 year interest rates near 0% have been very cheap and highly attractive for many years. We now learn Chinese property developers have financed their large scale projects on these short term USD borrowings.

It appears they have side-stepped Government reporting regulations on foreign currency leverage >= 1 year by accessing 364 day USD bond issues. Hence, they have been able to increase their outstandings beyond prudent limits. This edifice of liabilities may have looked cheap and too good to pass up but it now has all the perils of elevated re-pricing risk. The old phrase, “if it looks too good to be true, then it usually is” comes to mind.

Offshore funding has merit; however, it is a fundamental risk to not fully hedge interest rate and currency exposures or manage to tight tolerances within a holistic internal and external counterparty risk management framework. Currently, risk analysts would be flagging a broad array of financial VAR movements and limit breaches in many companies right around the world due to the aggressive rise in USD Libor short-term interest rates.

Beyond just major banks, all corporate boards and senior management need to firstly quantify the impacts of their foreign currency funding lines on their own balance sheet and secondly investigate the liability profile of their own downstream domestic and global supply chain, especially those domiciled in emerging markets.

Realistically, the widely reported capital outflows across emerging markets over the last month could be directly related to USD borrowings. Productive foreign investment may not be fleeing emerging markets at all. It might be the major banks and large corporates choosing to repay or restructure their funding profile of USD short term debt to responsibly manage their floating rate costs.

Remedial actions like these can be a responsible action to undertake. We may have witnessed a phase where heavily indebted counterparties have panicked in unison. Regrettably, they have all been subjected to the same trigger event of rapidly rising USD Libor rates. Overshoot always occurs when everyone rushes to do the same thing at the same time. This is where Central Banks use discretion to smooth these flows through a balanced interplay of currency intervention and monetary policy. The Central Banks of emerging markets like India, Indonesia, Russia, Turkey and Argentina have all intervened recently to stabilise the rapid decline in their currencies. Just this week, the Chinese Yuan traded at 6.6325, its weakest level since November 2017 and rapidly approached the lower level of their trading band. If Central Banks need to hold currencies steady and within acceptable trading bands to allow domestic clients to release domestic capital to repay foreign debt then so be it. I feel these events have been orderly thus far and should stabilise.

When Australia needed to purge itself of Swiss Franc (CHF) borrowings in the late 1980’s, the restructure of State Government, Bank, Corporate and SME balance sheets was a systemic event which needed immediate triage to a wide range of casualties.

Rating agencies will be assessing the funding mix of all their clients globally to assess the credit impacts, such as the availability of substitute credit and the profile of ongoing costs which may improve or deteriorate current period earnings and overall financial strength.

The greatest tsunami of capital flight I have witnessed was one that was symmetrical to this event. The weakening of USD/Yen from 250 to 80 in the decade between 1985 and 1995 was inevitable. This global repatriation had to occur to rebalance a domestic funding mismatch. The export success of the Japanese economy to all countries for the 40 years post World War II built up a Yen based edifice of domestic debt deployed as working capital. The asset profile comprised a broadly diversified foreign asset portfolio of global sovereign and corporate bonds, golf courses, property and partnership equity in foreign businesses in all countries Japan exported to, which was largely everyone.

The speed of the repatriation was very disruptive. The worst implication of this balance sheet mismatch underpinning Japan Inc.’s export domination period came to a disastrous end when their major banks were forced to merge in August 1999. The bank consolidation period in Japan spanned 14 years from 1990 – 2004. The weight of systemic risks overpowered many of the strongest banks when valuations plummeted and fire-sale liquidation or default ensued. Notwithstanding this calamity, Japan remains the largest creditor to the world but one who certainly lost their mojo for the last 20+ years. The influence of “Japanese Housewives” pursuing the carry trade and “Belgium Dentists” in conservative fixed income products is worthy of referencing for their influence on foreign exchange trading and capital markets. I expect to see Australian SMSF’s continue to develop a broader global risk appetite. These recent events are key learnings for prudent funding, investment and business managers.

I trust this USD short-term debt symptom offers manageable impacts to the global financial system. However, I sense quantitative tightening will present a series of tectonic shifts which I trust will be rapidly assessed and remediated by the global financial community.