When Jay Powell, president of the U.S. Federal Reserve, testified before Congress this week, the focus was on how the central bank helped U.S. companies and consumers during the pandemic. Senators had to ask – but did not do – what the central bank had done to help dollar markets off the coast of the United States.
It was a big omission. When future financial historians study the shock caused by COVID-19, they will conclude that the Fed’s intervention in offshore dollar markets through swap deals with other central banks was the most significant political move. Not only have the Fed’s actions calmed the markets, but they have strengthened the hegemony of the dollar’s global financial system for years to come.
It takes a little history to understand all this. The concept of bank swaps with which two institutions exchange currency is not new at all. This type of central bank cooperative has a long history between 1962 and 1998, according to a report by the Bank of International Settlements. But their use faded in the early years of the 21st century, when the Fed focused on the domestic dollar market and the US economy.
That changed dramatically during the 2008 crisis. Historian Adam Tooze notes that bankers have realized that non-US financial companies, especially those in the EU, have amassed massive, unbalanced dollar exposures. They owed dollars to investors, but could not secure enough currency in private markets, which sparked panic.
Lacking large reserves of US currency, the ECB had nothing to help. So the Fed created swap lines that allowed the ECB and central banks from four other countries – Switzerland, Britain, Japan and Canada – to offer dollars in local markets. The Fed has effectively turned other central banks into branches, thus extending the momentum of the dollar offshore segment.
After the crisis, there was a public debate about whether the Fed should abandon these “emergency” measures on the vital issue of their responsibility for offshore dollar markets. The shock of COVID-19 unexpectedly clarified this issue.
In the middle of Mrat, panic broke out again in the offshore dollar markets. Fed responded and even doubled the stakes. First, they reactivated swap deals with the five original central banks. They then added 9 players, including Mexico and Brazil. Finally, they added a buy-back option that allows entities outside the 14-member club to exchange assets such as government bonds for dollars.
This extended safety net is not exhaustive. Countries with emerging markets without large government securities, such as Turkey, remain isolated. And using the repo program is expensive, with few using it for obvious reasons. But 10 of the club’s 14 swap members have taken in $ 446 billion. In addition, the program has been extremely successful in its quest to calm markets. In mid-March, borrowers in euros and yen had to pay an additional 200 and 250 basis points, respectively, to borrow dollars; by the end of Aryl, this gap was only 30-50 basis points.
This is good news for financial players outside the United States. It also brings an unexpected geopolitical turn.
Since 2008, major imbalances in offshore dollar markets have migrated from Europe to Japan, with Japanese savers, banks and life insurance companies diving into dollar markets to drive higher returns. Thus, Norinchukin, the agricultural bank, became the largest holder of dollar-denominated loans in the world. Smaller banks, such as Shizuoka, also jumped. At the same time, the needs of Japanese “life insurers for US dollars in the foreign exchange swap market exceed $ 1 ton”
Before the pandemic, these imbalances began to worry Japanese regulators. The Fed’s intervention calmed fears. According to the latest census, the Bank of Japan took more than $ 224 billion from the Fed, much more than $ 143 billion from the ECB, and most likely gave it to dollar-hungry Japanese corporations. In simple language, a secure network is in place.
Will this be maintained after COVID-19? Almost certain: Fed officials and the Treasury increasingly believe that preventing unnecessary dramas in offshore dollar markets is necessary to avoid shocks to domestic dollar markets and the important bond sector.
Call this a new manifestation of American self-interest; or simply an inevitable consequence of financial globalization. In any case, the turning point is this: even if US global leadership is evident in many areas, the Fed’s support for dollar hegemony is not. This could increase the use of the dollar after the COVID-19 shock, even if countries like China hate the idea.
Source: Financial Times, Federal Reserve
Chart: Used with permission from Bloomberg Finance L.P.
Trader Aleksandar Kumanov