Saleem Bahaj and Fernando Eguren-Martin
The US dollar has a dominant role in the international financial system. The fact that trade and cross-border investment are overwhelmingly dollar-denominated means that non-US banks are heavily reliant on dollar funding (Aldasoro and Ehlers (2018)). This funding dried up during the Covid-19 epidemic, prompting the use of central bank swap lines as a policy response. This post looks at recent research on why dollar funding dried up in March, the efficacy of swap lines and the implications for cross-border banking, exchange rates and the international financial system.
Stresses in dollar funding markets
Eren, Schrimpf and Sushko (2020a) provide a detailed narrative of how the shock from the pandemic worked through US money markets and exposed non-US banks to dollar funding shortfalls. US prime money market funds (MMFs) that invest in commercial paper (CP) and certificates of deposits (CDs) are the marginal buyers of non-US banks’ dollar liabilities. This type of fund is potentially vulnerable to “runs” because of maturity mismatch: they allow daily redemptions, but liquidations of CP and CDs are costly as they are designed to be held to maturity.
Moreover, a general flight to safety led a reallocation of capital away from prime MMFs that invest in CP and CDs towards those that invest in treasuries. Hence, the pandemic led to large outflows from the prime MMFs that provide non-US banks with dollar funding.
The alternative source of dollar funding for non-US banks is the FX swap market. Non-US banks can borrow in their currency and remove the FX risk using an FX swap to generate “synthetic” dollar funding. However, high demand for synthetic funding raises its price. This manifests as a deviation from the covered interest parity (CIP) condition: the effective interest rate from borrowing in local currency and swapping into dollars exceeds the apparent interest rate from borrowing in dollars directly. Eren, Schrimpf and Sushko (2020b) show CIP deviations widened sharply during the initial phase of the Covid-19 market stress.
The Federal Reserve responded in a similar way to previous episodes of dollar funding stress (see McCauley and Schenk (2020)): by expanding and easing access to its swap lines with other central banks.
The swap works as follows: the Fed lends dollars to a foreign central bank at an interest rate set as a spread to the overnight index swap (OIS) rate of the same maturity (one week or three months). The foreign central bank then lends these dollars to its banks, collects collateral, and bears the credit risk. Against the loan of dollars, the Fed receives a deposit of foreign currency, which acts as collateral, at the foreign central bank. At the end, the Fed gets the dollars back with interest and returns the deposit.
If a bank can borrow dollars from its central bank more cheaply than borrowing in local currency and swapping, it will likely prefer to use the former. Bahaj and Reis (2019) show in theory that through such arbitrage, the spread that the Fed charges to a foreign central bank over the OIS rate puts a ceiling on deviations from CIP between that central bank’s currency and the dollar.
This ceiling result held well during the Covid-19 epidemic. Bahaj and Reis (2020a) analyse this period and document heavy drawings from the swap line in March which resulted in a rapid stabilisation in market conditions by the beginning of April. Crucially, the shift in swap line policy only seems to have narrowed CIP deviations among currencies whose central banks both have access to and have drawn upon the swap line.
Most of the effect on CIP deviations was apparent only after the first draw down on swap line after the policy intervention. Cetorelli, Goldeberg and Ravazzolo (2020a) add nuance to the effect on CIP, arguing that only the announcement and settlement of the more frequent swap line operations had the desired effect.
Interestingly, Eren, Schrimpf and Sushko (2020b) argue that the swap line has altered the functioning of the market for FX swaps during the pandemic. For those currencies for which the Fed offered swap lines, the pricing of FX swaps tethered to OIS rates instead of the usual unsecured rates (such as Libor). This is likely a reflection of the fact that swap lines, effectively the new outside funding option, are priced off OIS.
CIP deviations and bank behaviour
This matters for the financial system more broadly because the empirical literature shows that the price of FX swaps does feed through to bank behaviour. Ivashina, Scharfstien and Stein (2015) show that when European banks faced difficulties accessing dollar money markets during 2011-12, EUR-USD CIP deviations widened. And those banks then disproportionately cut back on dollar-denominated lending relative to other loans and other banks. Eguren-Martin, Busch and Reinhardt (2019) show, using UK data, that outside of crisis periods and for currencies beyond the dollar, there is a strong link between the supply of cross-border credit in a particular currency and the cost of synthetic funding in that currency.
Specifically regarding effects running through the swap line, Bahaj and Reis (2019) show that a cut in the swap line rate causes banks with access to have higher equity market valuations and to invest more in dollar-denominated assets (corporate bonds). This in turn raises the market value of those assets. Eren, Schrimpf and Sushko (2020b) find evidence from the current pandemic that banks with access to the swap line could borrow more cheaply in dollars from money markets as well. This suggests that the swap line works partly through establishing an outside option and influencing banks’ bargaining power.
This evidence, taken together, suggests that the Fed’s swap lines benefit the recipients in the sense that their banks face a lower cost of funding and have an increase in market value. But they also benefit the US by making dollar investments more attractive – this is particularly important in a stress as it prevents non-US banks selling into a fire sale. Cetorelli, Goldeberg and Ravazzolo (2020b) argue that the swap lines supported non-US banks’ activities in the US. Moreover, Akinci, Benigno and Queralto (2020) argue that there is also a macro benefit for the US in limiting the spillovers from economic disruption abroad.
Spot exchange rates and the macroeconomy
The swap lines appear to have a limited effect on spot exchange rates. To a first approximation this is unsurprising. The swap line can replace the dollar funding lost due to stress in US money markets, but depositors could still withdraw local currency to buy dollars if they are concerned about their own liquidity needs. The sharp FX moves during the pandemic have had a knock-on effect in local currency funding markets, particularly in emerging markets. Hofmann, Shim and Shin (2020) show that EME local currency bond spreads spiked sharply and argue that FX depreciations played a key role. When foreign investors take FX-induced losses, they are forced to liquidate their positions, leading to capital flight from EMEs, further currency depreciation and a further widening in spreads.
Funding tensions in US dollar markets can also spill over to the macroeconomy. Eguren-Martin (2020) shows that dollar shortages can have sizeable negative effects on emerging markets’ domestic bank lending via a combination of tighter collateral constraints and local currency depreciation interacting with mismatched balance sheets. The fall in lending can in turn depress investment, consumption and ultimately output. The presence of US dollar swap lines helps alleviate these dynamics.
Consequences for the international financial system
The stresses in US money markets may have a lasting impact on the structure of the international financial system. The uptake of central bank liquidity facilities funded through swap lines could suggest that these facilities are destigmatised. The extent of the Federal Reserve’s swap line network is likely also to be debated, particularly by emerging markets that experience volatile funding conditions and do not have access (the new FIMA repo facility may also address this). More speculatively, concerns over the volatility of dollar funding may renew interest in developing alternatives to the currency in global trade and banking. McDowell (2019) argues that the disruption in US money markets during the financial crisis prompted Chinese efforts to internationalise the RMB, including the establishment of a network of RMB swap lines. Bahaj and Reis (2020b) show that these swap lines have encouraged RMB usage.
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