When a central bank experiments it's like unleashing a bull inside a China shop; when that bank is the BoJ, not only the glassworks are in danger but the whole shop structure itself. The highly controversial BoJ's yield curve targeting not only creates serious financial distortions locally, but it is transforming them into a global threat; the risk of suspending all US dollar funding outside of the US. This can trigger a vicious cycle of defaults and an ultimate collapse of the global economy. While the importance of such a USD shortage risk for emerging markets has already been stressed, its underlying mechanism has not been well understood yet. This mechanism stems from the massive money printing of central banks like the ECB, BoE and BoJ, with the latter playing the central role. BoJ's role became prominent especially after it decided to control the shape of the Japanese yield curve, all the way from the front to the back end, in response to the ineffectiveness of its massive quantitative and qualitative easing program. This action increased demand for USD funding, while at the same time curtailed the available supply of such funding, inflating the cost of USD procurement. This could potentially lead to severe credit contraction, not only in Asia, but in Europe as well, given the massive cross-border links between their banking sectors. Have Chinese (NYSEARCA:FXI), Japanese (NYSEARCA:EWJ), and even US equities (NYSEARCA:SPY) priced in such a global threat? Most likely not. However, the most disconcerting thing is that as the current bullish trend of the greenback (NYSEARCA:UUP) extends itself, and as BoJ and other central banks print money at a historically high pace, the global economy is approaching closer to its potential melting point; the inability of global banks to procure and supply dollars to the world.
How BoJ Policy Fuels Demand for USD Funding
BoJ's monetary "splurge" makes the procurement of dollars increasingly prohibitive, in an environment of tightening banking regulations under Basel III and a reformed US money market. This congruence of structural, institutional, and political factors increases the demand for dollar hedging and reduces the supply of available dollars, making USD procurement prohibitively expensive.
Japanese investors - i.e. pension funds, wealth funds, institutional investors, and corporations - cannot find sufficiently high returns domestically to satisfy their obligations, since JGB yields have plummeted. Thus, they increasingly buy US-dollar denominated assets (mostly US Treasuries) to get the extra yield the need. However, they need to hedge the foreign exchange risk in order to be able to fulfill their future obligations. This can be achieved by engaging in a FX swap, i.e. borrow dollars in exchange for yen with the obligation to repay them at the future date at a predefined exchange rate (the forward rate). The difference between the spot and the forward exchange rate of a dollar-yen FX swap shows the implied interest rate, i.e. the cost that Japanese investors have to pay in order to hedge their foreign exchange risk. The more Japanese investors turn abroad to hunt for yield the greater the demand for USD hedges, and the higher the cost. In addition to this demand for USD hedging, Japanese banks themselves need to hedge the risk of their dollar loans to corporations across Asia Pacific, pressuring the cost of dollar funding even higher.
Apart from this BoJ induced surge in demand for USD funding, to satisfy hedging and loan provision, the supply of available dollar funding wanes due to BoJ's actions as well, making the FX swap market increasingly tight.
Falling Supply of USD Funding
The supply of dollar-yen FX swaps is falling because there are not enough short-term JGBs available in order for the providers of dollars - reserve managers, hedge funds, and other pools of money - to place the yen they receive in return for the dollars they lend. As a consequence BoJ's ultra stimulative policy, beyond inflating demand, reduces the supply of USD swaps. The dollar-yen cross-currency basis, i.e. the difference between the Libor rate and the FX swap implied interest rate for lending US dollars, is heading towards new all-time lows, lower than any other currency pair against the dollar. This proves that BoJ is quickly bringing the financial world to its limits, with its highly dangerous policy.
On top of this, a couple of structural reasons make the procurement of dollars increasingly tight. The provision of USD funding across the globe is based on a supply chain of US dollars, with its beginning inside the US banking system. Then these dollars are "wired" to foreign banks, which lend them to their clients through FX swaps. The implementation of the recent money market fund reform in the US removed a vital pool of cheap dollar liquidity which previously was available to domestic as well as foreign banks. In order, say, for a Japanese bank to lend dollars to a Chinese exporter, it would need to hedge the loan against the risk of dollar depreciation, by "buying" a dollar-yen FX swap. Before the money market reform the prime funds provided ample dollars to banks in order to facilitate such swaps with other counterparties, offering them at a reasonable price. After the reform this pool of liquidity was lost, forcing Japanese banks to tap the FX swap market en masse, in order to borrow the dollars needed to provide hedging services in their local market. This raised the cost of dollar borrowing through FX swaps way above the Libor level (the interest rate paid in London for unsecured USD funding), which should naturally attract global banks to reap a great profit opportunity; borrow USD in the cheaper Libor rate and lend the proceeds through the more expensive FX swap market. However, Basel III rules prohibit global banks from leveraging their balance sheets in an unlimited fashion, as in the past. As a consequence, global banks are not allowed or do not want anymore to take advantage of this excellent arbitrage opportunity and bridge the two costs. This gap, keeps the cross-currency basis deep into the red.
Essentially, the lower the interest rates of a currency are the biggest the cost of USD hedging, and this can be easily verified if one looks at the significantly thinner cross-currency basis of the higher yielding currencies such as the Aussie and the Kiwi. Central bank policy is the key to explain how distorted and dangerous the USD funding market has become.
Possible Chain of Events
Historically low JGB yields, bank's unwillingness to take more risk, structural reforms and an increasing reliance on USD borrowing on behalf of Asian corporations have created the biggest threat for the global financial system and the economy as a whole. Were cross-currency basis to reach historically extreme levels it could set in motion a devastating vicious cycle of bank deleveraging, corporate defaults on their USD-denominated obligations, a run on the yuan, and the collapse of the Chinese as well as the global economy. In such a scenario US equities would certainly get a big hit and the Fed would have to step in by unleashing its USD swap lines to crowd out the private sector in the global swap market. This would be feasible, of course, only in case the Fed doesn't clash with Trump administration, which is a scenario that cannot be ruled out.
The devaluation of a currency was traditionally perceived as beneficial for any exporter, either emerging or developed; but not anymore. The higher the use of dollar funding by any exporter, the bigger the negative implications a weaker national currency brings. This taken to its extreme could mean that an exporter heavily funded in dollars could very well suffer from the devaluation of its currency instead of benefiting from its trade gains. As a matter of fact, the rising US dollar and BoJ actions make this case increasingly likely, for Japanese and other Asian exporters. The vast size of cross-border US dollar-denominated claims between European, Japanese and US banks could allow Asian defaults to spread all over the world, exactly at a time that the European banks are the most vulnerable.
It seems that the new era of strict banking and money market regulation, is completely incompatible with the exorbitant money printing by some of the world's most profligate central banks. Either the world must stop basing its trade and funding needs on the US dollar, the BoJ (and the ECB) steps back from its policy, or the Fed picks up the dollar funding slack by unleashing its FX swap lines. If none of the above happens, then the world will most certainly end up in a financial disaster. Do politicians and central bankers have that "luxury"? Only time will tell.
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