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. 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
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. CIP deviations widened sharply during the initial phase of the Covid-19 market stress.
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 destigmatized. 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. Researchers showed that the disruption in US money markets during the financial crisis prompted Chinese efforts to internationalize the RMB, including the establishment of a network of RMB swap lines, which have encouraged RMB usage.