A decade of ultra-low interest rates and quantitative easing has flooded the globe with highly unstable forms of funding denominated in US dollars, with no guarantor standing behind them. Glaring currency and maturity mismatches have accumulated.
This structure is prone to an abrupt “US dollar crunch” should borrowers in China, east Asia, emerging markets, or parts of Europe start scrambling for scarce US currency in a crisis.
The report from the Robert Triffin International forum said the purely “private component of global liquidity” (defined as foreign currency credit to non-banks) has mushroomed to $US12 trillion. This now dwarfs the shrunken $US3 trillion pool of “official” liquidity, such as IMF resources, central bank swap lines, and even the eurozone bail-out fund (ESM).
This private liquidity is highly geared to spasms of risk appetite and overconfidence, and even more geared to panic when trouble starts. It can set off potentially unstoppable chain reactions. The liquidity is “destroyed” by forced deleveraging.
“As the 2008 experience shows, the supply of private liquidity cannot be relied upon in periods of stress,” according to authors Bernard Snoy, Andre Icard and Philip Turner, former top officials at the World Bank and the Bank for International Settlements.
They warned that there is no clear backstop. The IMF cannot plausibly come to the rescue in a major upset. Its resources have dwindled to just 1 per cent of global external liabilities, down from 4 per cent in the Eighties.
This is ominous since the so-called “balance of payments disequilibria” has become completely unhinged. “Global imbalances have now reached 40 per cent of world GDP… four times larger than in the 1990s,” the authors write.
Only the US Federal Reserve can act as the guarantor of a deformed monetary regime at the mercy of US dollar supremacy, or what the Bank for International Settlements calls the “global US dollar system”. Other central banks rely on currency swap lines from the Fed to shore up their own financial systems in an emergency.
It took some $US600 billion of Fed swap lines to halt contagion during the Lehman crisis in 2008, when the wholesale capital markets froze and offshore US dollar funding vanished. In other words, the Fed rescued the European Central Bank and saved the euro from an impending cataclysm. However, Fed support ultimately requires the political assent of the US Treasury and Congress. In Washington’s “America first” mood, there may be critical blockages in a fast-moving crisis, allowing a Lehmanesque event to spin out of control. The IMF has issued just a warning.
Key Fed figures from the Lehman drama – including Tim Geithner and Ben Bernanke – warn that post-crisis legislation such as the Dodd-Frank Act prevents the Fed from repeating such a rescue in extremis. New rules limit emergency help for foreign entities.
The core global problem is the disturbing level of dependence on fickle US dollar flows and shadow funding outside US jurisdiction. Neither the euro nor the yuan have made a dent on US dollar hegemony where it matters.
“Banks outside the United States… have US dollar debts which exceed the total liabilities of banks operating within the US. Their US dollar funding is vulnerable to any US dollar liquidity shock,” said the Triffin report. Under the IMF’s measure, the volume has reached $US18 trillion including swaps.
The BIS has a different gauge but the message is the same. US dollar credit to non-banks outside the US has risen to 14 per cent of global GDP from 10 per cent at the top of the financial bubble in 2007.
This unstable regime is tested whenever the US dollar strengthens, either because the US economy is powering ahead, or when fear triggers a flight to US dollar safety.
There are hints of this nervousness now as China’s coronavirus outbreak leads to supply-chain disruptions for global manufacturing, and as the Eurozone’s fragile recovery keeps disappointing. The US dollar index (DXY) has spiked over the past five weeks to 98.70 and is nearing a 30-month peak.
This US dollar squeeze tightens conditions for corporate borrowers in emerging markets – often overleveraged with short-term debt. Chinese developers, with big US dollar liabilities but with no US dollar revenues to act as a hedge, are being hit by a double whammy of a depreciating yuan and a financial shock from the virus.
While banks have stepped back since the Lehman crisis, the risks have migrated to the offshore bond markets and opaque capital flows.
Huge sums are being channelled through exchanged-traded funds and other instruments that promise investors liquid withdrawal at any time while locking the money into illiquid assets, a business model “built on a lie”, in the words of Mark Carney.
“The need to address the risk of a new US dollar liquidity crunch is urgent. It is essential to develop adequate frameworks before trouble strikes,” said the Triffin report.
Is anything being done? Not much.