China's Dollar Swap Addiction

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by: The Nattering Naybob
Summary

Discussion of $1T (ER) excess reserve deposit (IBDD) leveraged by Eurodollar and Euro/USD forward swaps held in NY Foreign Bank's.

Examination of Central Bank Forward FX Swap Usage.

Analysis of potential forward effects on PBOC and other EM central banks.

Discussion of effects on the dollar, commodities, global equities and bond markets.

Forward Currency FX Swap

A swap is a financial tool to ease transactions by exchanging certain elements of a loan in one currency, like the principal or interest payments into an equivalent loan in another currency.

Currency forward is an obligation of two parties to convert an agreed amount of one currency into another by a certain date at an exchange rate specified at the moment of signing the deal.

With forwards, not only are FX reserves conserved for other uses, but buying the local currency in spot markets with UST sale proceeds is not necessary, so the domestic float and liquidity does not suffer. However, future swaps just kick the can forward and can make the settlement of the debt, much more costly and difficult.

"If you have a transaction that settles down the road, the actual liquidity impact in the short term may not be as dramatic," said Citigroup's Steven Englander. "Down the road you can't avoid it."

Friday Oct 23rd FX Pairs

October 23rd - Enter The "Draghi" threw the Euro under the bus while CHINA cut, Dollar up but strange? Dollar down vs RUB, BRL and CNY?? So either someone had to cover on EUR funded FX carry trades? Or someone must be dumping treasuries and buying something with those dollars, ah yes, their own currency, lowering their float, raising ours.

Buying their own currency would be the traditional way. But, maybe something else is going on? Lets have a closer look.

USD/CNY Swaps

Note below, Bloomberg showing China's increasing use of 'forward swaps to support the RMB or Yuan.

Due to a global shortage of short term HQLA, China and other EMs are utilizing swaps as a LARGE part of their FX reserves. Making trading days near or on those settlement or rollover dates, potentially more tradable for liquidity volatility and market dislocations.

Euro/USD Swaps

This from Zoltan Pozsar at Credit Suisse re: Euro/USD and Eurodollars: "there are NY branches of foreign banks currently holding $1T in ER (excess reserves) funded with yankee and Eurodollar CD and CP issued to prime money funds, as well as interoffice loans from headquarters also funded by Eurodollar deposits and Euro/U.S. dollar basis swaps. This makes offshore dollar and short term HQLA liquidity an issue."

And this... "An uncapped mechanism could cause market dislocations as rapid flows would exacerbate eurodollar and short term UST liquidity issues, in addition to causing another dollar squeeze especially vs Euro". I noted some of the correlations in Mission Impossible: Correlations In Action? The Fed, PBOC, Treasuries, The Dollar And Swaps.

Forward Affect?

Coming full circle, last week Draghi threw the Euro under the bus effectively engaged the latter mechanism with those USD/Euro swaps and Eurodollar deposits, as well as some other mechanisms which we will Natter about shortly. Witness the dollar DXY last week, especially on Friday Oct 23rd, like a rocket from under 94 to 97, and it makes me wonderHow big would that dollar squeeze get without the bond dumping to counter it? China, Brazil and Russia are liquidating USTs'. Not so fast on that liquidation Joe... Maybe there isn't any bond dumping going on? Maybe somebody is swapping, gambling that the dollar will decline substantially at some point?

Last week from Bloomberg, in late August and September: "China's large state banks borrowed dollars in the swap market, sold the U.S. currency in the cash spot market and used forward contracts with the central bank to hedge those positions. The PBOC then came in to offset, or "square", the positions with the banks, essentially taking on their trades onto its own balance sheet, according to Goldman Sachs. Using derivatives for intervention had the benefit of delaying any decline in the PBOC's $3.5 trillion trove of foreign-exchange reserves... it was also faster as the monetary authority's managers didn't have to liquidate assets such as U.S. Treasuries to raise the dollars needed for direct yuan purchases."

Note the above usage of borrowed dollars, delaying and liquidate. Continuing on...

As promised above, those "other" mechanisms... As for borrowed dollars, the PBOC encouraged its dollar opium addicted banks, who are already in hock to their necks in dollar debt, to pay it forward by lighting up another bowl of greenbacks. The Euro getting Draghi-ed under the bus, just put those Chinese banks and the PBOC on the spot, dollar spot that is. But maybe not just those Chinese banks?

Ditching the Dollar?

As of Jan 1st 2015, $4T of China's FX reserves were in US bonds, or 32%. The US dollar constituted $162B of Russia's FX reserves or 40%. Many may not remember this, "Russia and China have long been looking for ways to cut the dollar's role in international trade. China has set up bilateral currency swap lines with more than 20 countries and regions since 2009, including Switzerland, Brazil, Hong Kong, Indonesia and South Korea, Xinhua News reported in July. China and Russia have effectively switched to domestic currencies in trading using financial tools as swaps and forwards, as they seek to reduce the influence of the US dollar and foreign exchange risks" - Dec 29, 2014 RT

But let's go back even further...

Sept 4, 2013 - FT - "If you're a central bank in emerging markets, struggling to keep your economy stimulated/protected from hot money flows, using swaps or FX sales is a tempting and viable alternative to interest rate hikes, notes BNP Paribas. Just ask one of the trend-setters Brazil... Whenever they want to prevent sharp movements on the USDBRL, they opt to sell USD via currency swaps or to buy USD via reverse currency swaps. Now, this sort of FX intervention has been spreading out among other EM countries with India and Indonesia following the BCB's steps, although with some differences. We think this can be feasible for Turkey as well."

What is the potential for a central bank with limited FX reserves to lend those out in fractional reserve fashion, in effect increasing dollar denominated liquidity in the FX market? And what happens when that trade goes bad, as in the dollar keeps going up?

If the Brazilian real is weaker than the level set in the forward swap contract, then the central bank had to pay out the difference and the transaction is settled in Brazilian reals. As the Real declined 63% vs USD, how's that working for Brazil, right about now?

"the outstanding dollar denominated funding mismatch must eventually be plugged with real reserves - or in the event that these are drained entirely, by tapping the Fed's own FX swap window to plug the dollar shortage." Keep your eye on the Fed FX swap window.

Or the central bank involved just prints its way out of the situation. The price being, their local currency gets devalued, just like Brazil, Russia, India, China, South Africa, South Korea, Singapore, India, Philippines, Malaysia and Thailand's did against the dollar. Every single central bank utilizing forward swaps vs the dollar has gotten torched. Would anyone like another bowl of greenback opium? South Korea, Singapore, India, Philippines, Malaysia and Thailand increased the use of forwards to $22.5B in August vs $6.5B in July.

Forward Effect?

As for delaying the day of reckoning for those future swaps and not just China's, the swaps still outstanding have to be either settled or rolled. All one need do is look at what happened to the BRL and RUB vs USD on a chart to see what happened when they settled out their previously massive forward swap positions, as in, their currencies were decimated.

China's talk of instituting a Tobin Tax is an act of desperation to stem the record capital outflows while masking systemic liquidity issues. "Capital outflows from China climbed to a record $194.3 billion in September, exceeding the previous high of $141.7 billion in August, according to a Bloomberg estimate that also takes into account decisions by exporters and direct investment recipients to hold funds in dollars. A gauge of foreign-currency assets held by Chinese financial institutions, including the central bank, declined by the equivalent of 761.3 billion yuan ($120 billion), also a record, official data showed Friday." - Bloomberg

As Bloomberg pointed out, in a flight to safety from their own equities, Chinese investors leveraged 10X (borrowed) to divert into their own corporate bond market. Yield premium of top rated Chinese corps over government is less than 1% which is insufficient to cover the rising credit risk with a contracting economy. Should capital flow back to equities, which it is, their bond market would feel the repercussions, creating a default hazard. Meaning that the bigger bubble, is their $6.6T debt market, which is leveraged to the hilt and based upon companies and a government that specializes in Chinese cook books.

"Andy Ji, a Singapore-based strategist at Commonwealth Bank, who predicts a yuan drop of more than 3 percent within a few days as soon as this year. The yuan hasn't fallen as much against the dollar as other currencies, he added, so "the offsetting effect from real appreciation renders monetary easing ineffective, especially when China is entrenched in a liquidity trap." - Bloomberg

Swapped Out?

With the Euro getting Draghi-ed under the bus last week, the aforementioned $1T in ED (eurodollar) and Euro/USD swap leveraged foreign bank ER (excess reserves) IBDD (interbank demand) deposits sitting in New York already started smoldering as the DXY jumped 94 to 97 and seems to be heading back to its 52 week high at 100.

It is the rolling of forward swaps against the dollar that will either win the day for those EM currencies whose central banks are making such bets, or break them. A dearth of offshore dollar and short term on the run liquidity coupled with the central banks forward dollar swap can kicking dance, is a bouncing vase filled with "Greek fire" waiting to detonate. If it does, aside from other contributing factors (continued downward global economic trajectory concomitant with an amplified Q4 seasonal contraction of monetary flows), the dollar by force could catch a rocket ride and put a dagger into commodity prices.

By the way, regardless of which way a forward dollar swap transaction goes, it's immediate affect is to print dollars into the system or increase the "dollar" float. One can only imagine, regardless of mechanism, forward dollar swaps or foreign central bank UST bond liquidation, how high the dollar might already be. When the forward swap transaction is unwound, if the dollar is higher, the foreign central bank involved must come up with the difference to either rollover the contract or close it out.

So either, the eventual sale of FX Reserve UST's and other assets, which the swaps were used to delay, or the central bank involved would print more local currency, devaluing their own currency and domestic bonds. The latter being a disaster waiting to happen in China's $6.6T corporate bond bubble.

China has rolled their swaps forward from August to October, then to December. A day of reckoning may be on the horizon, as in the Chinese dollar opium addicts may have overdosed. When they do settle up on those forward USD/RMB swaps, the valuation could decimate the RMB, just like the massive devaluation on Aug 11th. Deja vu for the ensuing global unwind of carry trades and the liquidity based disorder and dislocations of Aug 24th. Food for thought.

Would like to thank you folks fer kindly droppin in. You're all invited back a gain to this locality. To have a heapin helpin of Nattering hospitality. Naybob that is. Set a spell, Take your shoes off. Y'all come back now, y'hear?

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