Could Currency and Funding Mismatches be on the Horizon?

The quarterly report by the Bank for International Settlements does not express it in so many words, but its warning of possible currency and funding mismatches illustrates the reason why the much ballyhooed Chinese swap lines are misunderstood. 

Recall that during worst of the Great Financial Crisis in 2008-2009, there was no G7 currency intervention.  Instead, officials recognized the main problem was not foreign currency prices per se, but the use of dollar funding.  The Federal Reserve responded accordingly and established currency swap lines with a several countries to make buck funding available through nationwide central banks.  These swap lines were used to different degrees.  The swap outlines for the ECB, BOJ, BOE, BOC, and SNB were changed into permanent structures of the worldwide architecture in the form of standby agreements at the end of 2013.  Although the exchange lines, and now standby contracts, were bilateral, the US never used the ability. 

Chinese officials saw the US exchange lines and erroneously believed this was part of the US initiatives to re-impose a dollar-centric order.  These people responded by extending their very own network of currency exchange agreements.  Barring a single exclusion, they have not been drawn on.  Yet, it has not avoided observers from claiming these people represent the internationalization of the yuan.  

In the actual BIS quarterly report released over the weekend, authorities warn that a continued appreciation of the dollar will squeeze many corporations from emerging market economies.  There are two stations by which this will happen.  First, many of these businesses issued bonds denominated in foreign currencies, especially US dollars.  The BIS estimates such entities experienced issued $2.6 trillion of these obligations, of which three-quarters was denominated within US dollars.  Second, international banks have lent about $3.One trillion as of mid-2014, mainly in dollars, to such companies. 

Borio, the head of the monetary and economic department of the BIS, had been quoted on the news wires saying that "Should the US dollar, the dominant international currency, carry on its ascent, this could expose currency and funding mismatches by raising debt burdens.  The related tightening of financial conditions could only worsen once rates of interest in the US normalize."

Moreover, an increase in forex borrowing preceded the Latina American debt crisis of the late 1970s and early 1980s.  It presaged Mexico’s Tequila Turmoil in 1994-1995. An increase in hard forex borrowing also took place within the run-up to the Asian financial crisis within 1997-1998.  

According to the BIS data, overseas lending rose by 400 bln in Q2 2014 to surpass $30 trillion.  The fir.2% increase in the year from mid-2013 had been the first increase since the late-2011.  Not even close to being part of the solution (through the internationalization of the yuan), China is part of the problem.  BIS figures indicate that outstanding loans by international banks in order to Chinese businesses doubled in the 18 months to mid-2014 to $1.1 trillion.   

The low level of US interest rates, and the dirty peg that keeps the yuan shadowing the US buck, made it attractive for Chinese companies to borrow dollars.  The actual currency mismatch may not be as large as it is for companies from other emerging market economies with a freer exchange price regime.  However, the 3.8% dollar appreciation of against the yuan within first four months of this 12 months was sufficient to wipe out more than a year of the interest rate cost savings.  Even now, the dollar is about 2% higher against the yuan than it was at the beginning of the year.  The difference between your US and China’s prime rates are about 225 bp annualized.  

The fact that set exchange regimes have largely been jettisoned (with the notable exception of Hong Kong and OPEC countries), the chance of a repeat of the earlier emerging market crises tend to be perceived to have lessened.  The greater flexibly currency regime does not prevent the kind of currency mismatch that has resulted in past crises.  It is true that lots of emerging market economies have amassed large reserves of hard currencies.  These reserves can be employed to resist a forex decline or address an industry imbalance.  Precisely how they can be used for a private sector currency or funding mismatch is less instantly clear. 

What the various crises over the past 40 years or so have in common is a currency or maturity mismatch that was accelerated just prior to the start of the crisis.  The  fairly low US interest rates relative to domestic rates available in rising market economies, and the depreciation of the dollar, which was broadly seen in structural rather cyclical conditions, encouraged such behavior.  This worked until the dollar and US interest rates rose.  

Many experts put the onus on the Federal Reserve.  When it eased policy using orthodox and then unorthodox guidelines to avoid a harder downturn, critics say it should not have done so.  It was exporting deflation.  Because it prepared investors for the end of its unorthodox measures, some have complained the US is actually exporting inflation.  

The Federal Reserve is not the central bank for the world, but of the United States.  Still, it recognizes its importance.  This had revealed its motives to investors months before it was going to slow its asset purchases.  It even waited a few months after it experienced appeared to signal the beginning of it’s tapering.  It has been warning investors since the beginning of the year that after an unspecified “considerable period” after the long-term asset purchase plan was completed, it might raise US interest rates.  The actual clearest signal from the Fed’s leadership is that this process will likely begin around the middle associated with next year.  Of course, it is dependent on the data but barring a substantial surprise, those with potential financing or currency mismatches, have just as much warning as can reasonably be expected.    

Meanwhile, China’s yuan swap lines go unused.  The yuan may be a lot of things, but it is not an international funding currency.

BIS Quarterly Report Shows China’s Exchange Lines Misunderstood is republished with permission from Marc to Market