Why a Strong Dollar Indicates Continued Stress in the Financial System

With over US$8 trillion committed by the US government and the Federal Reserve in various programs to keep the financial system functioning, a US$787 billion stimulus package already passed, and an imminent bank rescue package that ostensibly start at $500 billion and be expanded to US$1 trillion, the Chinese (as the largest foreign holders of US treasury securities) are rightly worried about the value of their "loans" to the US, in the form of US$727 billion holdings of US treasuries (up 52% YoY) as of December 2008. Yet the USD and US treasuries have remained bouyant despite bear calls for a substantial sell-off in both. Generally, the strength is attributed to "safe haven" buying. As far as the USD is concerned, the reality is probably more like distressed buying.

In the March 2009 BIS Quarterly Review ("The US dollar shortage in global banking"), Patrick McGuire and Goetz von Peter analyze why the USD has strengthened in the face of the global financial crisis. Basically, this strength is a reflection of continued financial system stress.

According to the BIS data, banks' foreign positions surged from 2000, with the outstanding stock of BIS reporting banks' foreign claims growing from $11 trillion at end-2000 to $31 trillion by mid-2007. Continued large US balance of payments deficits were like a huge ATM for the global financial system, providing an abundant supply of USD. This acceleration coincided with substantial growth in the hedge fund industry, the emergence of the structured finance industry, and the spread of "universal banking". The growth of European banks' global positions was particularly noticeable. USD-denominated positions accounted for over half of these banks' overall increase.

These "long" USD positions were funded primarily by borrowing in domestic currencies. European banks' combined long USD positions grew to more than $800 billion by mid-2007, funded by short positions in pounds sterling, euros and Swiss francs. As banks' cross-currency funding grew, so did their hedging requirements and FX swap transactions, according to the BIS research.

But the freezing up of credit markets from October 2008 after the failure of Lehman Brothers suddenly meant that these banks were unable to roll over their short-term funding positions, requiring the banks to deliver foreign currency and forcing them to sell or liquidate assets earlier than expected. This created a substantial USD funding gap. The global credit squeeze tightened like a vise, threatening the viability of banks from Iceland to Belgium.

The BIS paper estimates that the European banks' USD funding gap reached $1.1 trillion~$1.3 trillion by mid-2007. Until the crisis, the European banks were able to meet their USD funding gap by tapping the interbank market and by borrowing from central banks, and using FX swaps. As interbank lending froze, FX swaps became dysfunctional and non-bank sources of funds dried up, the global financial system faced a potential wholesale run on the banks.

Seeing this funding gap threatened the very viability of the global financial system, the Fed and its central bank peers cobbled together a coordinated policy response to provide USD to banks outside the US. As the scramble for USD reached crisis proportions, the Fed's swap lines with the ECB, Bank of England and the Swiss National Bank became unlimited in order to accomodate any quantity of USD borrowing against collateral.

Since the height of the crisis, European banks' net USD claims on non-banks have declined by some 30%, and while the worst of the funding crisis has apparently passed, the USD index has remained strong, which indicates that heightened credit risk concerns, crippled short-term funding and efforts by European banks to plug huge holes in their balance sheets continues to produce strong demand for USD.

An estimated JPY20 trillion (USD204 billion) reversal of yen carry positions that rocketed the yen to near-historical highs in the mid-JPY80/USD range early this year was a symptom of this critical USD funding shortage. But while the passage of majority of this unwind in addition to seasonal repatriation of funds by Japanese investors has removed fund-flow support for the yen, USD continues to be well-supported.

From this standpoint, one of the earlier signals of an "all clear" sign regarding the global financial crisis could be a significant sell-off in USD, which in turn would put downward pressure on US treasuries. While the US can probably depend on the loyalty of Japan as the second largest owner of US treasuries (at $626 billion), one cannot help but wonder how the Chinese would react to seeing the value of their "loan" to the US substantially depreciate.

Comments

[Dirk McCoy:]

How have the Chinese reacted to their "loan" appreciating lately? Considering the dollar has dropped 30% or so since 2001, you'd think they'd appreciate the renewed strength.

Many Chinese companies have learned some hard lessons of capitalism and market economies this year. Perhaps the Chinese government needs to learn that what goes up can go down.

But fortunately for them, the productive capacity of the US that stands behind the dollar (and the productive capacity of all nations that accept dollars in trade, which is pretty significant) means they don't have to worry about their holdings falling as far as, say, US real estate or equities. And they should be really happy they're holding more dollars than pounds or euros...

Mar 16 10:48 AM

[mkreisel:]

When smart investors look at the impending collapses of East European economies, the imminent state bankruptcies of Ireland and Spain, the impotence of EU governments, and the balance sheets of European banks, they know where to park their money.

Mar 16 06:10 PM

[kelm:]

This makes a lot of sense. The stock financial media response to a rising dollar - flight to quality - has always sounded too "stock" to be a complete answer.

The Chinese are under intense domestic pressure to ratchet back their holdings of US Treasuries. Their people don't like funding us. Yes, we have a symbiotic relationship but if the Chinese succeed in moving their economy more towards a consumer based one, and especially if Asia does as well, then their need for us is dependent on how quickly and strongly they perceive we will re-emerge from this crisis. If their perception is that we are damaged longer term, then their calculus will be quite different.

We should note as well that they have taken substantial losses in their equity investments during 2007 in US and other foreign markets. So they have been burned and are fearful of being burned more all of which feeds into a potential domestic backlash.

Mar 17 10:28 AM

[derryl:]

I think there's a simpler way of explaining the ongoing demand for and thus strength of US$. Before English, Latin was the language of international commerce. If you wanted to do business across borders you had to 'have Latin'. Before the US$, gold was the currency of international commerce. If you wanted to do business across borders you had to 'have gold'.

The past decade has seen a vast expansion of cross border economic and financial activity which required increasing quantities of US$ to facilitate. Some of those dollars came from US balance of trade deficits but those 'real' international dollars were then leveraged to create debts of even more US$ than the amount that was actually circulating. Now the debts are being called and there's a shortage of US$ in international circulation. Anyone who has dollars is parking them in the US Treasury rather than risking them in commerce. Everyone who needs dollars is willing to pay a premium for them.

As globalization increases the demand for the world's international currency will remain strong. If global trade decreases then, after the current dollar debts are either defaulted or paid out, we should see some weakening of the US$.

Mar 18 01:27 AM