King dollar is rising. Other currencies are falling like ninepins. But to gauge the impact of this surge on Asia, you have to move beyond spot exchange rates and into an esoteric corner where tens of trillions of dollars of off-balance-sheet debt lives in the accounting footnotes of banks, investors and even central banks.
That corner is currency swaps. These are deals in which parties exchange funds from one currency into another and reverse the trade, say, five years later. Every three or six months, each earns a benchmark money-market interest rate in the currency it bought and pays interest in the currency it sold. The greenback is usually involved, and a basis swap spread is a measure of how much more a bank has to pay to borrow dollars by this circuitous route rather than taking an outright Libor loan. An average of the spread on G-10 currencies is an indicator of the punishment for wanting and not having the US currency.
Theory says there should be no such dearth of dollar funding obtained synthetically, but since the 2008 crisis there’s a scarcity that comes and goes, signalling fear ahead of rockiness in the global economy. Right now, the dollar squeeze isn’t awful, but it’s worsening, with implications for everyone from Japanese banks and South Korean insurers to the Indian government.
Start with the poor, rich Japanese banks. If staying home is no fun for them, going out is worse right now. Money is so cheap in Japan that banks are paid to borrow in yen. That crimps the profitability of their domestic lending business. But what happens when they try to make a little bit of assured profit on those borrowed funds by buying, say, US bonds? On a 10-year treasury note, they lose an extra 40 basis points over and above the negative 20-basis-point yield on a Japanese security of similar maturity.
A Tokyo mega bank that wants to raise financing against safe US bonds to make a dollar loan to, say, Masayoshi Son, is caught on the wrong foot as hedging costs make treasuries costly to own for Japanese buyers. Banks whose home currency is dollars will be able to offer cheaper loans. Korean insurers are in a similar boat. Unable to earn what they’re crediting to their policyholders, they’re also desperate for higher-yielding foreign securities. But if they buy 10-year US Treasuries, they effectively surrender nearly 80 basis points of the 1.2% yield on the sovereign Korean bond. As the Korean central bank cuts rates further, meeting policyholders’ expectations will become onerous.
Japan is the world’s biggest international creditor, with $3.2 trillion more in overseas claims than what it owes foreigners. For Korea, that figure is in excess of $400 billion. Being frustrated by US yields is annoying for creditor nations, but the money that’ll stay trapped at home could potentially ease domestic financial conditions.
Most Asian countries are net debtors, however. For them, wanting cheap global funding to finance high-yielding assets at home and not getting it is a more vexing challenge. When a debtor nation sees its basis swap spread widen, they’re “unable to substitute smoothly to other domestic funding channels,” a recent International Monetary Fund working paper noted.
Take India, which owes a net $436 billion to foreigners, and is perched a rung above Italy on the sovereign ratings ladder, according to Moody’s Investors Service. The 10-year Indian rupee bonds offer 6.4%, versus 1.5% in euros on the Italian benchmark. However, Japanese investors looking to lock in returns in yen will get a 1.6% yield pickup in Italy, while they’ll lose money on the Indian bond. (Small wonder that they’re rushing headlong into Italian debt.) This is the reason why New Delhi, once it makes up its mind about a recently proposed maiden issue of sovereign debt overseas, will struggle to attract global investors to a rupee offer.
Currency swaps are crucial even to central banks. The negative yields at home that make Japanese banks miserable enhance returns for the Reserve Bank of Australia (RBA), which diligently swaps some of its foreign-exchange reserves into yen. Two years ago, RBA deputy governor Guy Debelle even gave a speech, titled “How I Learned to Stop Worrying and Love the Basis.” Not everybody can be as sanguine. Australian lenders can lend cheaper to homeowners by borrowing in greenbacks and converting the funds to Aussie dollars than they can from dipping into the limited deposit pool at home.
The rest of Asia will watch the G-10 basis swaps closely. If the dollar tightness lingers, it could be a predictor of something big and bad.