The global financial crisis should have served as a salutary lesson in the dangers of the dollar’s dominance in global finance. It didn’t.
Over the past decade, the volume of dollar loans to, and dollar-denominated debt issued by, companies outside the US has continued to balloon. Via the Bank for International Settlements, the pre-eminent source for both data and analysis of global finance’s reliance on the greenback:
Many of us are aware this is a bad thing. Which is why we argued last week that providing a cheap and plentiful supply of dollars to the rest of the world is one of the best things the Federal Reserve could have done.
Yet the assumption is often made that this is primarily an emerging market story, a tale of firms in places like China leveraging up with dollars only to get caught out when the FX market moves against them.
Of course, that’s a big part of the story (for reasons set out here). But dollar funding has predominantly risen in advanced economies. Here’s the same BIS chart with an additional line drawn for emerging market borrowers:
Not only does most of the burden lie with borrowers in advanced economies, they’ve also been fuelling most of the growth.
In some respects this is hardly a surprise.
Imagine you’re a Japanese life insurer. An ageing population has a large savings pool and bloated your liabilities. At the same time years of ultra-low interest rates have left you chasing yield. There is one place in which you can make a little more money without seemingly taking on too much risk: the US or in dollar assets outside the US.
When the insurer wants to invest in dollar assets, say a ten-year US Treasury bond, it needs to swap yen for dollars most likely from a bank based in Japan. What determines the rate at which the bank will charge? Well it depends how much the counterpart bank itself can source the dollars for.
Increasingly, when foreign banks have sought to borrow dollars they use an FX swap to exchange their domestic currency for dollars. This would involve, say, a Japanese bank borrowing dollars by pledging yen as collateral. This is equivalent to buying dollars for yen in the spot market, and arranging to buy back the yen at a pre-agreed rate at some point in the future. Usually that point is less than three months.
Here’s the BIS data for outright forwards and forex swaps with dollars on one side of the transaction:
And here’s the same chart for the yen:
So how does this play out when the entire world is on a rampage into the dollar and fears of counterparty risk are shooting up? Avid readers of the financial press may have noticed themselves reading the term cross-currency basis swap spreads frequently over the past few weeks. Here’s what it is and how it’s calculated, according to a March 2008 BIS paper:
And here’s what has happened to the spreads over the past few weeks, again via the BIS:
Understanding the drivers behind the dollar funding boom helps shed light on why the Fed rushed to provide swap lines on new and improved terms to its counterparts in advanced economies such as the Bank of Japan, the European Central Bank, and the Bank of England.
We think international borrowers in advanced economies are an important part of the story in explaining why we have seen assets like US Treasuries and US equities move in the same direction. The jump in dollar funding costs was so exorbitant that it was wiping out any yield they might have gained, forcing them to sell the US assets or fund their greenback borrowing at a loss.
So are the Fed’s lines helping to calm markets? The data in the chart above show the seedlings of a reversal over the past few days.
We wouldn’t expect the cash crunch to end here. But the Fed has certainly helped itself in managing stresses in the US Treasury market and elsewhere through its offer of cheap, plentiful supplies of the greenback to places like Japan.
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