Central Banks Leave Banks High And Dry

Last week, the Federal Reserve and the European Central Bank each raised their rates by half a point. The Fed increase is the seventh in a row, bringing the two main rates to 4.25% and 4.50%, while the ECB is at its fourth increase in a row, up to 2.50% and 2.75%. The Bank of England is also in on the game, having implemented nine consecutive increases before reaching 3.5%.

Both the Fed and the ECB made it clear that further rate increases will follow, with the aim of reducing inflation by draining liquidity. However, the immediate result will be a rise in the cost of refinancing dollar or euro denominated debt, which will hit developing countries in particular, but also a G7 member such as Italy, which has a 130% debt to GDP ratio. Countries will default as Ghana did on Dec. 19. But at the same time, the African country obtained a $3 billion loan from the IMF, conditional on harsh austerity – which will generate output losses. This amounts to fighting debt with more debt.

The largest debt, however, is that linked to derivatives, the dimensions of which no one really knows because it is “hidden”, meaning that over-the-counter financial bets do not appear in the banks’ balance sheets. Recently, the Bank for International Settlements estimated at $97 trillion the volume of over-the-counter foreign exchange derivatives in all currencies. The “hidden” exposure of major non-American banks, to foreign exchange derivatives based on the U.S. dollar, is estimated at $39 trillion. For comparison, the total capital of these banks is no more than $3 trillion, while their “unhidden” dollar-denominated liabilities (i.e., those on the balance sheets) are about $15 trillion; and most important, the total reserves of the world’s central banks held in U.S. dollars only total about $7 trillion.

Translation: Should these banks urgently need to meet a substantial share of these liabilities with dollars, there would not be enough in all the world’s central banks , and the Federal Reserve would have to print many, many trillions more. This would correspond to the point in Lyndon LaRouche’s “Typical Collapse Function/Triple Curve”, at which monetary aggregates must be printed into the stratosphere in an attempt to keep unpayable and devaluing debt from collapsing completely.

Within the last three years alone, there have been three episodes of acute dollar liquidity shortage in major international banks, fund management companies and, ultimately, in central banks other than the Federal Reserve. The first was the August-September 2019 breakdown of the international market for interbank loans in dollars, which triggered QE5 on Oct. 4, 2019, with the Fed pumping hundreds of billions of dollars in daily liquidity loans into big banks. The second was in March 2020, as global demand vanished in the COVID pandemic. The third began in March-April 2022, due to NATO sanctions against the world’s largest commodity producer, Russia, generating margin calls for dollars throughout energy and commodity sectors and markets, etc.

None of these episodes have come close to bringing down the trans-Atlantic banking system yet. The Federal Reserve and other major central banks have been able to prevent that, so far. But they are like the proverbial man falling from a skyscraper who does not get hurt – until he smashes into the ground.