EM banks exposed to stress in FX swaps, a spillover from US repo markets

Global financial system made vulnerable by the absence of a true lender of last resort

Hung Tran

A woman walks past a currency exchange office in Cairo, Egypt
A currency exchange office in Cairo. EM banks are increasingly reliant on volatile FX swaps markets for short-term dollar funding © EPA

Much attention has been focused on potential stresses in the US repo market. More attention should be paid to the FX swap market, which non-US banks and other entities have relied on for short-term US dollar funding.

Recent changes in supply/demand conditions for US dollar funds in that market could make it more susceptible to stresses. In particular, emerging market banks have become more exposed to risk.

Despite fears of another spike, US repo rates traded normally over the year end — in fact much more so than at year end 2018. The benign outcome owed much to the US Federal Reserve conducting repo operations and T-bill purchases to add about $400bn of reserves since September 17, increasing its balance sheet to $4.16tn.

Also helpful were reported changes in repo market strategy by at least two major US banks.

These changes include using total return swaps to mimic repo trading and asking clients to use “sponsored repo” deals through the Fixed Income Clearing Corporation (FICC) — both of which attract lower bank capital charges than regular repo trading. This allows those banks to participate in the repo market in a capital efficient way.

Also reflecting efforts to avoid higher capital charges, many US banks have tried to reduce trading with non-US clients. This, coupled with the use by foreign central banks of the Fed’s foreign reserve repo pool (to the tune of $250bn, down from a high of $306bn in September) has the potential to reduce the supply of US dollars to the FX swap market.

Meanwhile, non-US banks have relied ever more on the $3.2tn-a-day FX swap market.

According to the Bank for International Settlements (BIS), non-US banks have about $14tn of US dollar assets, not all of which are funded with liabilities such as deposits, loans and bond issuance. The FX funding gap — estimated by the IMF to be about $1.5tn — needs to be covered by borrowing in domestic currencies, swapped into US dollars.

Column chart of US dollar liabilities of non-US banks, by booking location showing dollar funding needs are back at pre-crisis levels

The heavy reliance of non-US banks on the short-term FX swap market has kept cross currency swap rates persistently deviating from covered interest rate parities since the 2008 financial crisis.

Basis spreads are currently fluctuating between minus 20 and minus 40 basis points for major currency pairs.

The FX swap market has been tightly linked to the US repo market, whose turmoil in September was quickly transmitted to the FX swap market, pushing the three-month euro-dollar swap basis from minus 22 basis points to minus 42 basis points. Non-US banks needing US dollar funding are thus at the mercy of developments in the US repo market, and of potential declines in the supply of US dollar funds.

Particularly vulnerable are non-US banks headquartered in emerging market and developing economies (EMDEs). According to the recent World Bank report “Global Waves of Debt”, EMDE banks have increasingly replaced global banks headquartered in Europe, the US and other advanced economies in supplying FX loans to EMDE borrowers — which have increased their FX debt to about $4.6tn, 80 per cent of which is in US dollars and, increasingly, in bond issuance (see the IIF's Global Debt Monitor, November 2019).

The BIS found that in mid-2018, EMDE banks posted an outstanding amount of $1.4tn of cross-border loans to EMDE borrowers, out of their total cross-border loans of $3.7tn — compared with $2.2tn out of $29tn, respectively, for banks in advanced economies.

Consequently, EMDE banks have become as reliant on the FX swap market as non-US banks in general to cover their FX funding gap. Moreover, using exotic currency pairs, EMDE banks have to deal with illiquid segments of the FX swap market, involving much larger basis spreads — fluctuating between minus 200 and minus 400 basis points for Taiwan dollar-US dollar swap rates, for example — as well as wider bid-ask spreads and much greater volatility.

As such, EMDE banks are highly vulnerable to stresses in the FX swap market, transmitted from the US repo market, that threaten to shut them off from a vital but fragile short-term FX funding source.

The policy response appears obvious if not sustainable. Central banks in EMDEs where residents have incurred much FX debt need to be ready to intervene in the FX swap market, playing the role of “swapper of last resort” to moderate spillover effects from US repo market turmoil.

In fact, as reported by the BIS studying the case of Brazil, central banks supplying FX derivatives against FX risks of local borrowers could reduce by half the negative effects. Of course, those central banks can only be “swapper of last resort” for as long as their finite FX reserves last.

The fundamental vulnerability of the current financial system remains the absence of a true lender of last resort for non-US banks carrying huge US dollar liabilities.

Hung Tran is a non-resident senior fellow at the Atlantic Council and former executive managing director at the Institute of International Finance.

Iran’s Revenge Plans Are Bigger Than Missile Strikes

Iran will use the networks Suleimani built to avenge his death.

By Zach Dorfman

 Iranian mourners gather around a vehicle carrying the coffin of slain general Qassem Suleimani
Iranian mourners gather around a vehicle carrying the coffin of slain general Qassem Suleimani during the final stage of funeral processions, in his hometown, Kerman, on Jan. 7. Atta Kenare/AFP via Getty Images)

The assassination of Maj. Gen. Qassem Suleimani, perhaps the second most powerful person in Iran behind Supreme Leader Ali Khamenei, will reverberate in the Middle East and beyond for years, and perhaps decades.

But the immediate consequences, several U.S. intelligence officials say privately, will be clear: more deaths, and some of them American. Tuesday’s noisy attacks, despite the reassuring words of the Iranian Foreign Minister Mohammad Javad Zarif that they were a “proportionate measure,” were only the beginning.

Those killings will be carried out using tools Suleimani, who was assassinated in Iraq by a U.S. drone strike, himself built. The institution Suleimani led, the Quds Force—the Islamic Revolutionary Guard Corps’ powerful hybrid military intelligence agency and covert action wing—midwifed Shiite extremist groups in Lebanon, Iraq, Yemen, Syria, Afghanistan, and elsewhere.

Suleimani understood that, unlike Russia or China, Iran was not, and would never be, powerful enough to challenge the United States head-on. It would have to prepare for war differently. This meant establishing deterrence (in Iran’s thinking) against a U.S. attack through asymmetric means, by supporting proxy forces such as Lebanese Hezbollah, the world’s most formidable terrorist army. It also meant backing spectacular acts of violence that did not rise to the level of, and would not precipitate, full-scale war.

The effectiveness of Suleimani and Iran’s larger program of terrorist assassinations, roadside bombs known as improvised explosive devices (responsible for the deaths of over 600 U.S. soldiers), and the bombing of apartment buildings, Jewish community centers, tourist buses, and diplomatic facilities by Iran’s proxies showed that a state could forgo traditional means of power projection and nevertheless powerfully assert its suzerainty outside its own borders.

Those same tools will now be brought to bear by Iran on enacting vengeance for Suleimani—and not just in the region itself. Senior U.S. Defense Department and intelligence officials are well aware that assassinating a senior official from a foreign military hierarchy exposes U.S. personnel to lethal retaliation by Iranian or Hezbollah operatives, who have tentacles in South America, Southeast Asia, Eastern Europe, and elsewhere. This retaliation is certainly likely now. “The devil you know is better than the devil you don’t,” said one former senior intelligence official of the killing of Suleimani. “We crossed a line.”

Prior high-profile U.S. killings, including those of the al Qaeda leader Anwar al-Awlaki in Yemen and, recently, of the Islamic State leader Abu Bakr al-Baghdadi in Syria, differ from Suleimani’s in a key way: Though Suleimani also facilitated acts of terrorism, he was, foremost, a high-ranking government official. This is a distinction with a real significance.

By ignoring this nonstate-state actor divide, the Trump administration has whittled away at a key global norm, one that may boomerang back, dangerously, on U.S. officials. It is hard to know now what bright lines are left in the impending confrontation between the U.S. and Iran.

“From this justice will come unpredictable chaos,” said Douglas Wise, a former Defense Intelligence Agency deputy director and former longtime senior CIA official—a sentiment echoed by over half a dozen former U.S. intelligence officials I’ve spoken with since Suleimani’s death. Some former officials worry about the potential for Iraq to fall back into civil war. Others are concerned about a rising anti-American tide across the Middle East and a forcible withdrawal of U.S. forces from Iraq and the region. Most are shocked by the apparent lack of advance planning and deliberation by the Trump administration in making such a momentous move—a decision that could lead to war.

Middle Eastern intelligence officials are themselves “gravely concerned” over the U.S.-Iran conflict “becoming an unending cycle of high impact and retaliatory mass violence,” according to a former U.S. intelligence official in close touch with current officials in Iraq. “Suleimani ran Iraq with the supreme leader’s approval,” said this person. “So you killed Suleimani: Does the Supreme Leader look at Suleimani as an extension of himself? If so, then it will be a long, bloody battle.”

The Iranians have built up “long-term spy networks” in such places as Kuwait, Bahrain, Saudi Arabia, and the United Arab Emirates, according to the same former official, that are used to inform potential Quds Force planning for potential future covert operations. This enables Iran to “push the pressure points”—including military or terrorism-type actions—in these countries if need be, said the former official.

Further bloodshed—beyond Tuesday night’s scattered rocket attacks in Iraq—appears inevitable. “There is little doubt the U.S. will get hit hard in retaliatory strikes, perhaps globally and at a time and place of Iran’s choosing,” said Marc Polymeropoulos, a former senior CIA official with extensive Middle Eastern and counterterrorism experience who retired in June. “This event will not be without significant pain for many Americans.” Other former senior U.S. intelligence officials agree. “There will be dead Americans, dead civilian Americans, as a result of this,” said former acting CIA Director Michael Morell in an interview with CBS.

Iran has been preparing for this type of asymmetric conflict with the United States for decades, whether as a response to limited U.S. strikes to destroy Iran’s nuclear program or as a reaction to a long-feared, frontal U.S. assault on the regime itself. Going back to the 1990s, in the Middle East, Latin America, Europe, and North America, U.S. officials have observed Iranian intelligence operatives and their Hezbollah proxies casing U.S. diplomatic facilities, cultural centers, and military bases for potential attacks.

Iranian operatives have also stalked U.S. officials abroad for potential assassinations. Around 2013, U.S. officials scrambled to stop what they believed were imminent plans by Iranian intelligence officials to undertake targeted killings of undercover Defense Department intelligence officials in Europe. U.S. officials believe that the information that led the Iranians to identify those officials was provided by a former Air Force intelligence officer, Monica Witt, who defected to Iran in 2013.

With this outbreak of hostilities, Witt’s stock has likely risen in Iran. “It’s possible any information Witt provided may have become operationally stale, but Iranians can come to her and ask about the perspective of their target,” said Wise, the former Defense Intelligence Agency deputy director. “She can provide great value to them there. Her perspective on how the U.S. government may now take steps to defend itself against inexorable Iranian asymmetric attacks may be helpful in Iranian asymmetrical planning.”

In order to not invite an overwhelming U.S. military response, Iran may opt for a more diffuse campaign of violence focused on lower-profile targets. These will likely involve U.S. personnel or facilities abroad, former officials said, such as the anonymous bombing of U.S. diplomatic outposts in Latin America, Southeast Asia, or the Middle East; or the targeted killing of CIA officers working under diplomatic cover whose identities are known to Iran or Hezbollah. Such a campaign—especially if carried out by Hezbollah—would follow the playbook written by Suleimani himself, providing Iran the ability to inflict great pain, repeatedly, on U.S. targets, while also helping maintain a fig leaf of deniability over its actions.

If, as former U.S. intelligence officials fear, the conflict spirals, some believe that Iran or its Hezbollah proxies may choose to strike inside the United States. Iran has shown a willingness to cross this line in the past. In 2011, U.S. officials foiled a plot by the Quds Force to assassinate the Saudi ambassador by bombing a popular Washington, D.C., restaurant. Suleimani’s protegees—and his mentor, Khamenei—may be looking at a range of what they seem as proportional targets in retaliation to the killing of such a senior Iranian official.

Last year, two Iranian men, including one based in Los Angeles, pleaded guilty to working as Iranian intelligence operatives. One cased a Jewish center in Chicago and assembled targeting packages on Iranian dissidents within the United States. And in a separate case, Ali Kourani, a Lebanese American man, was found guilty in 2019 of working as a Hezbollah operative in New York and assembling potential targeting data on local U.S. government facilities and John F. Kennedy International Airport.

The Kourani case, in particular, may offer a peek into the future. In 2010, Kourani was told by his Hezbollah bosses to research current or former Israeli soldiers living in New York for potential assassination, according to court documents. This, Kourani said, was retaliation for Israel’s killing, two years earlier, of Imad Mughniyeh, Hezbollah’s chief operational leader.

Memories are long. The initial outbreak of hostilities—a few missiles lobbed at U.S. military bases in Iraq, or maybe later across the Persian Gulf; a bombing of U.S. diplomatic facilities—may give way, over time, to a long, hard tit-for-tat campaign spanning continents: not quite a war, but far from a state of peace.

The philosopher Hannah Arendt once wrote that “the practice of violence, like all action, changes the world, but the most probable change is to a more violent world.” Suleimani’s bloody legacy testifies to that.

Zach Dorfman is senior staff writer at the Aspen Institute's Cybersecurity and Technology Program and a senior fellow at Carnegie Council for Ethics in International Affairs. Follow him on Twitter: @zachsdorfman.

The End of Retirement

The conventional wisdom—save enough to retire at age 65—won’t work for the generation starting their careers today, writes columnist John D. Stoll.

John D. Stoll

Illustration: Ruth Gwily

It took about six years of annual asset reviews with my financial planner, Joe Mackey, to confront a big question. After I spent my entire adult life trying to save enough to quit working by 65, Mr. Mackey wanted to know what my rush was.

“Do you even think you’ll want to retire?” I’m a 42-year-old writer with a job offering travel, intellectual grist and social connection. With few hobbies and an allergy for sitting still, it’s fair to assume my view of a comfortable retirement includes more work than quit. Maybe I’ll deliver the mail, write books or teach.

People spend a lot of time wondering if they’ll have the means to retire, often ignoring the equally important calculation: Do they have the will to retire? A job, historically seen as simply a way to make money, is increasingly the source of the types of friendship and stimulation that are hard to find in bingo halls, on beaches or riding a golf cart.

“When my friends and I talk about our futures none of us says, ‘When I’m 65 I’m going to retire and live on a farm and do nothing,’ ” says Kevin Frazier, a former legal assistant at Google who is now pursuing joint law and public-policy degrees at Harvard and the University of California, Berkeley. Mr. Frazier, age 26, watched his dad work a 30-year career at AT&T,but the one-employer tenure is no longer status quo.

Mr. Frazier is representative of the way many entering the workforce today think. Routinely told they won’t have the cash to retire and can expect to live longer and healthier lives than their parents, Gen-Z workers have plenty of motivation to pursue employment even after they become eligible for Social Security.

“When people leave school it’s not going to be for 25- or 30-year careers, it’s going to be for a 50-year career,” says economist Olivia Mitchell, a professor at the University of Pennsylvania’s Wharton School of Business. Dr. Mitchell says actuaries (the people trying to figure out how long beneficiaries will live), are now projecting people entering the workforce could live 125 years. And that’s just a starting point. 
“Some demographers say the baby who will live to 200 years old is already born,” Dr. Mitchell says. Average life expectancy in the U.S. is 78, according to the World Bank. “People in their 60s today look very much like people in their 40s not long ago,” she says.

This view of aging is shaping our career aspirations. Mr. Frazier, for instance, expects to dice up his working years into 20-year increments devoted to potentially different areas of interest. He reckons he’ll take a sabbatical. Others I talk to say they will work part time or even go back to school later in life.

A 2018 Transamerica Center for Retirement Studies survey found half of 6,372 workers polled don’t expect to retire at 65, and 13% plan never to retire. The number of people who plan to retire after 65 has increased threefold since 1995, according to Gallup. America’s average retirement age has increased in the past 25 years to 66 or older.

Much of this sentiment is due to the barrage of headlines about rising health-care costs and Social Security shortfalls. Boston College professor and economistAlicia Munnellsays it’s smart to encourage today’s workers to stay employed until at least 70 years old in order to accumulate more savings.

But there are other reasons to stay employed. In her book, “Working Longer,” Dr. Munnell says the physical demands of work have declined and it has become “much more personally and socially rewarding.”

With U.S. birthrates falling and membership in religious institutions at all-time lows, work is addressing a void once filled by children, churches or community organizations.

Overall, people are working more—a half-hour longer every weekday versus 12 years ago—and spending less time socializing, attending community events or participating in sports and exercise, according to the Bureau of Labor Statistics.

Careers are already getting longer. Today, the only age group with a growing labor participation rate is those 55 and older.

If the modern concept of retirement seems outdated, Dr. Mitchell says, it’s because it was forged around the Great Depression when Social Security was established as an insurance plan for the elderly finding themselves unemployed. Back then, the majority of Americans who made it to adulthood could expect to live only to 65, according to the Social Security Administration. That’s when potential benefits kicked in.

Richard Johnson,a senior fellow with the Urban Institute, a nonpartisan policy research group, says it’s deteriorating health and poor job satisfaction—not money—that most often inspires someone to leave the workforce. People who can and want to stay in the workforce also live longer lives and face a lower risk of dementia, depression and obesity, according to research by Matthew Rutledge, an economics professor at Boston College.

People spend a lot of time wondering if they’ll have the means to retire, often ignoring the equally important calculation: Do they have the will to retire? Illustration: Ruth Gwily 

For those wanting to keep working it is easier than in the past to remain sharp and productive, says Pam Jeffords, an employment expert advising on future workforce issues for PricewaterhouseCoopers. Now largely confined to speakers and smartphones, voice assistants could one day be ubiquitous, making digital work easier.

Developments in semiautonomous vehicle technology will make commuting safer; automated processes can reduce physical or mental demands; and an abundance of retraining efforts give more opportunities to revive or learn new skills.

Dr. Mitchell, the Wharton professor, says the rise of the so-called gig economy (think Uber drivers and Airbnb owners) offers a view into what future opportunities could await some people who step out of a full-time job and seek fewer hours or more flexible arrangements. Some experts call these bridge jobs or “unretirement jobs,” John Laitner, a University of Michigan retirement expert, says.

Patagonia, the outdoor clothing maker, is among an army of companies analyzing how it will deal with a rising tide of older employees. Dean Carter, the California company’s human-resources chief, says the company is intent on providing a “glide path” for people nearing retirement who don’t want to simply fall off a “cliff.”

Mr. Carter and others at Patagonia started to tackle this more intently about 18 months ago when longtime employees signaled they were thinking of hanging it up. The company realized it would be a mistake to see its “elders” walk out the door because there wasn’t a way for them to work less formal schedules, and began to implement changes.

The company’s longtime editor, for instance, has left her day-to-day role editing company materials, but she is teaching younger charges how to write in the “Patagonia voice,” Mr. Carter says. Other elders are spending time in the lunchroom at the Ventura, Calif., headquarters passing down stories; traveling the world lecturing on the company’s culture; or conducting sessions on the environment.

Meanwhile, my financial planner and I revisited the question of retirement. I’ve agreed to fund my 401(k) at a pace where I can quit in about 25 years—not so I can stop working but so that I have options.

This fits the future, according to law student Mr. Frazier, even in the early days of what he expects to be a long career. “I feel zero pressure to retire on time—whatever that even means.”


Jeremy Grantham on divesting from Big Oil

A contrarian investor on the hazards of owning fossil-fuel stocks

Late last year Jeremy Grantham, an investor routinely described as “legendary”, spoke about esg (environmental, social and governance) investing at a conference in London. His presentation was slick; his accent floated somewhere in the mid-Atlantic (Mr Grantham is English but has lived in America for ages). “I love s and g,” he began. “But e is about survival.”

Three-letter abbreviations have been a constant in Mr Grantham’s professional life. He is the g in gmo, which stands for Grantham, Mayo and van Otterloo, the fund-management group he co-founded. His firm has a distinctive philosophy: it favours companies with low share prices relative to measures of fundamental worth, such as cash flows or the value of assets. Mr Grantham owes much of his public profile to his decrying of stockmarket bubbles.

This sort of hard-headed, long-termist approach also informs Mr Grantham’s views on environmental policy. And his conclusion is that investors should avoid owning oil stocks.

It is a call that raises hackles. Committees that set investment policies for pension funds fear that if they shun oil stocks it will be harder to reach their financial goals. Mr Grantham checked the data to find out whether, and how much, omitting the stocks of any industry over three decades would have hurt a hypothetical investor.

He created synthetic portfolios that left out each of the ten broad stockmarket sectors and compared their returns with the market as a whole.

The results were surprising: it made hardly any difference.

The s&p index returned an average of 9.71% annually between 1989 and 2017; the index excluding energy stocks returned 9.74%.

The range of returns, from the worst portfolio to the best, was just 0.5 percentage points.

This finding seemed like it might be a fluke. But a further check, going back to 1925, had a similar outcome.

The spread between the best and worst portfolios was 0.54 percentage points; there was hardly any gap between the portfolio with energy stocks and without them (see chart). This is worth knowing, whatever your views on esg.

The market, it seems, has done rather a good job over time of pricing stocks so that no broad industry group yields abnormal returns.

Mr Grantham believes that oil might yet prove an exception.

Oil demand has already peaked in rich countries and, as climate fears grow and green technologies become cost-effective, it will eventually peak worldwide. But not everyone is keenly focused on this prospect.

Scepticism regarding climate science is common in America. To the extent that sceptics are investors, and are betting on business as usual, at least some of the risks facing Big Oil may not be in the price.

Investors might, for instance, miscalculate the speed of transition to greener energy. Advances in materials science and battery technology are making electric vehicles a cost-effective alternative to petrol-fuelled cars, Mr Grantham reckons.

Other potential hazards face oil companies, including increased regulation and costly lawsuits. In other industries, such as tobacco, firms have been forced to pay up when found to have knowingly sold harmful products. He thinks the oil industry faces a similar reckoning.

Is there also a moral case for disinvestment?

An argument against is that oil firms are best placed to speed the transition to solar and wind power. They have experience of managing big projects in difficult terrain. And many would say that dumping oil stocks is a pointless salve to the eco-warrior’s conscience.

Bill Gates, a software mogul and philanthropist, has argued that people should not waste idealism and energy on a policy that will not cause any reduction in the use of fossil fuels.

What matters are incentives set by governments: tax breaks to fund research in green energy; tax rises to discourage carbon use.

But this misses the point, says Mr Grantham: “You have to make the oil industry a pariah for bad behaviour.”

Only then will politicians feel the need to act.

A lot of finance types quietly suspect that greenery is anti-capitalism in metastatic form. Mr Grantham is clearly not of this anti-business persuasion.

That makes it far harder to dismiss his arguments out of hand.

“This is the first time that a major industry has been put on notice that it is going out of business, even if it may take a long time,” he says.

His arguments pose a challenge to investors: do you really want to go along for such a bumpy ride?