New York | In the last issue of The Institutional Risk Analyst, "Elizabeth Warren Wants to Crash the Global Financial Markets," we talked with Ralph Delguidice about why the spread differential between the dollar markets and other liquid offshore markets is thwarting efforts by the Federal Open Market Committee to restore liquidity in domestic money markets. When the New York Fed provides liquidity to the primary dealers, that cash does not necessarily “trickle down” to the rest of the money markets. Indeed, a good bit of it goes offshore seeking to maximize yield.
One example from our discussion last week is the vast offshore market in dollar lending by non-US banks and governments, lending that is largely unreported. Horn, Reinhart and Trebesch note in their must-read paper for NBER, “China's Overseas Lending” (2019):
“[T]he government of China holds more than five trillion USD of debt towards the rest of the world (6% of world GDP), up from less than 500 billion in the early 2000s (1% of world GDP)… China’s total financial claims abroad amount to more than 8% of world GDP in 2017. This dramatic increase in Chinese official lending and investment is almost unprecedented in peacetime history, being only comparable to the rise of US lending in the wake of WWI and WWII (Horn et al. forthcoming). Indeed, the rapid growth of claims have transformed the Chinese government into the world’s largest official creditor (the largest overall creditor remains the United States). Despite these developments, however, we know strikingly little about China’s capital exports and their global implications.”
The chart below shows LIBOR interest rates for dollars, yen and euros. The rest of the interest rate complex denominated in the three largest global currencies rests upon these basic short-term rates. It does not take much time to see that a Chinese bank able to borrow at a negative yield in euros or yen and swap the debt payments into dollars has enormous arbitrage opportunities.
The fact that the members of the FOMC actually believed they could raise short-term interest rates anywhere close to 3% is entirely ridiculous in view of the spread differentials shown above. More than half a century since Bretton Woods, the community of economists in the US, including the members of the FOMC and the Fed’s staff, still tend to think about monetary policy in purely domestic terms. Most economists ignore the impact of interest rate differentials and how these spread relationships can impact the demand for dollars and short-term interest rates.
The funny part is that American economists can prattle endlessly about the “special” attributes of the dollar as a reserve currency, yet somehow miss the impact of this fact on the interest rates that prevail in domestic US markets. The fact of low or even negative rates in Japan and the EU is driving demand for dollars, which non-US banks and governments use to make loans. Even at just 1.7% this AM for overnight forward Treasury repo transactions, zero risk dollar assets are extremely attractive for offshore investors.
The short-dollar overhang in the offshore Eurodollar market is a key factor behind the dollar’s strength -- and has been for 75 years. Many US economists take comfort in the special relationship of the dollar as a “reserve currency,” but totally miss the other side of the coin – namely that the end of that special status implies disaster for the US economy. As the former Chairman of the Joint Chiefs of Staff Michael Mullen warned in 2011: “I believe the single, biggest threat to our national security is debt.”
Growing debt is certainly a threat to the role of the dollar as a reserve currency, but the debt also provides the liquidity that makes the dollar market function as the world's prefered means of exchange. The greenback accounts for something like three quarters of global commercial and financial transactions, especially when you factor in currency swaps and hidden debt described by Reinhart et al and the Bank for International Settlements we discussed last week.
For the US central bank, offshore demand for dollars makes calibrating policy to achieve the entirely domestic mandate in the Humphrey-Hawkins law increasingly difficult. Since the end of WWII, nations around the globe have used dollars as both a means of exchange in trade and as a store of value for central bank reserves. Even large nations such as the EU today remain chronically short dollars, an important fact that is often ignored by US policy makers.
Without a steady supply of fiat paper dollars, the global economy would essentially come to a halt. But the flip side of that coin is that short-term interest rates in the US must be measured against the interest rates prevailing in other major nations if US monetary policy is to be effective.
How do we shake the FOMC and the wider economics profession from their domestically focused lethargy when it comes to understanding (or better, remembering) the global dimension of the dollar system? Richard Gardener in his classic book "Sterling Dollar Diplomacy" (1956) described the creation of the dollar system after WWII. He ends the work with these lines from John Maynard Keynes classic essay on "National Self-Sufficiency" (1935):
"Words ought to be a little wild, for they are an assault of thought upon the unthinking. But when the seats of power and authority have been attained, there should be no more poetic license.... When a doctrinaire proceeds to action, he must, so to speak, forget his doctrine. For those who in action remember the letter will probably lose what they are seeking."
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