Misunderstanding Eurodollars

|
Includes: CEW, FXE, JEM, UDN, UUP
by: Alhambra Investment Partners

They cannot say they weren’t warned. Though the World Bank’s (and IMF) proclamation was a bit condescending and parochial, it was very much fitting. There was a short window, which more than suggests high-level discussion among central bank figures, into which these “emerging market” economies might begin painful adjustments in order to better weather the coming dollar storm. Despite the fact that modern central banks, as evidenced by every single “developed” economy central bank, are set up so that economies only experience painful adjustments via involuntary disorderly “market” events, the cabal of economists may have actually expected Brazil, India, et al, to act contrary to their nature.

Now that emerging market turmoil has gained a much wider audience, particularly from those that ignored it previously as irrelevant, there has been a flood of commentary advertising “explanations” for the “sudden” appearance of crisis. Most of it contains bland generalities that you would expect from TV personality-types, but even of the seemingly more sophisticated you still see the obvious lack of depth in understanding.

The primary distraction along that line has been commentary linking emerging market distress to the US current account. This usually takes to the form of the US “exporting” fewer dollars abroad. Any such statement betrays a full lack of awareness about how the dollar system actually functions, and thus any commentary containing it is immediately invalidated.

The eurodollar system has no (repeat, NONE) connection to the US current account. The amount of dollars available for global trade here is only linked to the willingness of banks participating in eurodollar markets to create them. This was one of the main features by which eurodollars replaced gold.

During the 1950s and 1960s the US monetary system was “plagued” by Triffin’s Dilemma (or Paradox), which simply stated the reality of an open monetary system of a reserve currency (particularly under convertibility). In order to allow growing world trade, the US had to “export” dollars through a persistently negative current account, but in doing so created a convertibility crisis because the amount of dollars exported would jeopardize the very ability of the US to convert them to gold. And that did occur, leading in 1960 to the creation of the London gold pool.

Thus, at that time, there was a direct link between US monetary policy and global trade currency. But that was conclusively broken in the late 1960s before the Nixon administration betrayed the dollar in 1971. The eurodollar/swap system sought to delink the US system from global trade by offering an alternative market for obtaining dollar-denominated financing.

At first, the US government was hostile, including the Fed. But by 1970, the rules were changed and the eurodollars were embraced. It is no coincidence of the timing of that acceptance, as monetary officials (particularly Treasury) saw the viability of moving outside of gold’s forceful limitations on government activities (the so-called petrodollar).

Indeed, for the first decade and a half beyond the gold exchange standard, eurodollars provided the marginal basis for dollar expansion apart from US domestic monetary factors. And it was a disaster right from the start – the Latin Debt Crisis was the first warning about substituting debt for hard money settlement. But by the 1980s, it had become durable enough to begin changing away from strictly trade financing to increasing financial intrusion. Rather than supplying dollars separately for trade, eurodollar markets became a means of raising “funds” for the new investment bank/shadow bank model.

Once the eurodollar futures market developed sufficient volume and acceptance in 1985 (along with swaps trading), the financial element within eurodollars grew disproportionately. And that became a problem in 2007-08 as there existed no direct entry for any central bank or monetary authority. That was the essence of dollar fragmentation, the epicenter of the panic of 2008 that nearly destroyed the global financial system. And it had nothing to do with the US current account.

Any link to the Federal Reserve, coming from the willingness of eurodollar participants to offer “dollars,” is purely psychology. Banks have extended eurodollar loans, through balance sheet expansion, under the course of QE because it is an explicit promise of dollar availability through other means, such as swap lines with foreign central banks. A eurodollar bank knows (or thinks it knows) that it can borrow eurodollars and extend dollar credit because the rollover risk has diminished with this alternate dollar funding mechanism.

Such leverage is then somewhat suspicious in that eurodollar participants have been “fooled” into believing the Fed would continue to be as explicit for a longer term. Taper talk undercut that belief, causing eurodollar participants to increase their margin of safety (volatility calculations feed into here) and reduce the amount of eurodollar credit on offer. Again, the pathology here was not that there was a reduction in the amount of dollars flowing in a “pipeline” of “reserves” directly from the Fed into eurodollars, but that eurodollar banks grew more cautious about extending themselves with a reduced promise from the Fed (and volatility that fed into that).

Emerging markets’ dollar problems are thus totally unrelated to the US current account. This is a financial matter, pure and simple. This is not to say that the current account does not have any impact anywhere, China being an obvious example, but that the “supply” of dollars for global trade is purely financial and it is largely independent of US economic factors. That is why the bond selloff had such an oversized impact on emerging markets, and it had little to do with “flight to safety” or “flow of capital.” Instead, it was a reflection of taper-driven concerns leading to fewer dollars on offer from financial balance sheet changes in the wake of remodeling financial limitations.

Thus is taper, even threats of taper – remodeled financial limitations. Good luck with that, Brazil, India, Turkey, Thailand, etc.