The rise and rise of currency hedging raises risk to the financial system
The writer is director of Belgrave Capital Management and Banca del Ceresio
The dollar has strengthened by around 20% over the past year and experts generally attribute this performance to rising interest rates and safe-haven buying during turbulent times.
While the first reason seems more specific, the main channel through which rising US rates impact the dollar is poorly understood despite the vast implications it has for the current configuration of the international monetary system.
The rising value of the dollar in times of crisis is often interpreted as a flight to a perceived safe haven, but in reality, this is largely due to the need for non-US investors to buy dollars to cover losses on assets. in dollars or reduce the hedges on them.
After decades of chronic current account deficits, the United States has attracted vast amounts of foreign capital to finance it and has accumulated a deficit of external financial assets against liabilities of more than $18.5 billion. Foreigners currently own more than $14 billion in dollar-denominated bonds. About half is held in the form of official reserves, with the rest mostly in the hands of investors in countries with chronic current account surpluses.
Foreign institutional investors most likely hedge the currency risk on their dollar-denominated bonds. For any investor with a risk budget or subject to risk-based regulation, holding a foreign bond unhedged is not attractive, given currency volatility.
Moreover, backed by academic studies, investors have developed more conviction about the direction of interest rates and equity markets than currencies. Thus, they often prefer to bet on the former but hedge the latter. They usually hedge their risk by selling the greenback and agreeing to buy their home currency at a later date.
Over the past year, investors have suffered substantial losses as bond prices have fallen around the world and interest rates have risen. And as the value of their dollar bond portfolios fell, foreign investors had to adjust their hedges downward, buying back dollars and selling their home currencies.
This is an activity usually carried out by the back offices which adjust the size of their foreign exchange hedges at least quarterly to the value of the portfolio. Precise data on the share of foreign holdings of dollar bonds that are effectively hedged are not available. But about half of the $14 billion in dollar-denominated bonds held as official reserves are unhedged. We would assume that around half of the remaining $7bn, or £3.5bn, is covered. Losses on US bond portfolios have been around 20% this year, so the proportion of unwound hedges would have been around that level.
This means that foreign investors would have bought back around $700 billion, an amount likely far larger than the speculative flows chasing the dollar for another reason.
The adjustment of hedges is therefore a determining factor explaining the strength of the dollar over the past year. We have seen similar patterns in recent crises. The other explanation for buying paradise dollars has never been convincing in cases like the financial crisis, when the United States suffered from bank failures in the midst of a real estate crisis.
If my hypothesis is correct, there are profound implications for our system of floating exchange rates. One of the main ways in which international imbalances were to remain contained was that a country with a chronic current account deficit such as the United States would at some point suffer a depreciation of its currency because foreign investors would be saturated with the risk of dollar-denominated assets. This depreciation would then help the United States to rebalance its current account.
But a Dutch pension fund, for example, holding Treasuries on a hedged basis is unlikely to be saturated with US risk. Indeed, on the one hand, the Treasury will not default on its obligations because it can print dollars to repay them. And, on the other hand, the risk that excessive printing of dollars will lead to devaluation is covered by currency hedging. In this way, the surplus countries are ready to accumulate more liabilities of the deficit nations.
In doing so, the financing of imbalances is added to cross-border financial flows which are constantly growing. The United States’ debt to foreigners is increasing, as are their claims on the United States. The financial system is required to mediate these ever-increasing balances, which weighs heavily on bank balance sheets.
More fundamentally, chronic imbalances increase measures of potential financial instability such as debt-to-gross domestic product ratios. We must tackle these new and unrecognized dynamics before the international financial system accumulates more risk than it can bear.