Ten years after the financial crisis, the specter of a global US dollar shortage is once again showing up in wholesale funding markets. Movies such as The Big Short depicted the previous crisis as the result of homeowners and Wall Street gone wild. The consensus perspective is that inadequate supervision of US mortgages, coupled with greed, ultimately led to an economic disaster. The prevailing logic is that the large size of the US economy and the intensity of the US downturn ultimately led to a global crisis.
The last crisis illustrated how global banks were reliant on US dollar funding
While the issue of defaulting mortgages and poor lending standards in the US was the initial catalyst of the last downturn, the issue goes much deeper. As best described in The Secret History of the Banking Crisis, the real story in 2007 was that the global Eurodollar funding system came to its knees. A Eurodollar is an offshore dollar (note the term 'euro' represents an offshore unit of a currency and should not be confused with euros) that can be borrowed in wholesale markets. As Eurodollars are outside the jurisdiction of the Federal Reserve, offshore US dollars enjoy minimal regulation. As such, both deposit interest rates and lending terms tend to be more attractive relative to onshore US dollar funding markets.
At the time, major banks in countries such as the UK, Germany, Switzerland, Japan, and Korea borrowed heavily from Eurodollar markets and invested the proceeds domestically and in the US mortgage market. This was a lucrative trade given the relatively low interest rates required to borrow Eurodollars and higher yields on mortgage loans and international investments. Prior the crisis, the US dollar gently weakened as the rapidly expanding supply of Eurodollars kept the currency in check. Once the financial crisis began, Eurodollar markets began freezing up and offshore banks were unable to roll over their significant US dollar liabilities. Simultaneously, the US dollar rose sharply in value as foreign exchange markets sensed panic. Until the Federal Reserve agreed to bail out foreign banks by instituting US dollar swap lines with key central banks around the world, US dollars were in extremely short supply.
US dollars once again in short supply
As can be seen below, the cost to borrow US dollars using euros for a 3-month period has dropped to minus 1% as of today. Negative numbers signify higher funding costs. Last year's increase in US dollar funding was blamed on US regulations that prevented US money market funds from investing their proceeds offshore. This time, there is no simple narrative to explain the ongoing US dollar shortage.
3-month euro-dollar cross-currency basis swap
Source: Bloomberg, MarketsNow
The harsh reality is that the Eurodollar problem is back. Looking at data from the Bank for International Settlements, commercial banks in Japan, Germany, France, and the UK once again have more US dollar denominated liabilities compared to those in their own currencies. Given the allure of low cost US dollars provided by Eurodollar markets, few banks can resist the temptation to engage in the trade. According to a story in the Wall Street Journal, Japan's top three banks have doubled their non-yen deposits by $600b in the last five years. Meanwhile, Danske Bank (a leading Danish bank) has issued 80% of its bonds since 2015 in US dollars. As the year-end approaches, demand for US dollars is rising sharply as global banks seek to roll-over their US dollar liabilities.
Total US dollar liabilities for non-US banks now exceed $9T, above crisis-era highs. This can be seen below:
Eurodollar liabilities for non-US banks
Source: Bank for International Settlements (March 2017)
As era of good times continues, impact on spot exchange rates to be limited
Despite the acute shortage of US dollars as measured by cross-currency basis swaps, the impact on exchange rates is likely to be limited today. Looking at EUR/USD and USD/JPY this morning, the dollar is selling off against both currencies (despite the high cost of borrowing USD versus euros or yen in the Eurodollar market). Thanks to the ongoing bull market, problems occurring in Eurodollar markets are seen as arcane and mostly irrelevant. Furthermore, lenders are far more willing to lend when economic conditions are buoyant, and thus the threat of a complete breakdown of the Eurodollar funding market is unlikely today.
Instead, this issue is likely to crop again when the next crisis strikes. This time, the Eurodollar market is even larger than in 2007, and a much higher proportion of US dollar liabilities is held in emerging markets such as China. Whether or not the Federal Reserve is willing to bail out the world with US dollars again remains to be seen.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.