It is very possible that everyone will blame the next Global Financial Crisis on the U.S Dollar, because since 2009, the key driver of financial markets has been liquidity. All asset prices have been affected by the Central Banks’ attempted reflation. According to one estimate, over 80% of equity prices are supported in some way by Quantitative Easing policies. Today, as much as $200-250 billion in new liquidity each quarter may be needed to simply maintain asset prices.
But now the world is entering a period where monetary policy will diverge between Central Banks. This has implications for both markets and asset prices. The U.S Federal Reserve is scaling back, terminating purchases of Government Bonds and Mortgage Backed Securities (“MBS”), which at their peak provided more than $1 trillion a year in new funds to the markets.
While new purchases have ceased, the U.S Federal Reserve does not plan to sell its portfolio of around $4 trillion of securities. It will continue to reinvest principal payments from its holdings of MBS and roll over maturing Treasury Bonds. The combination of maintaining its balance sheet at sizable levels and low official interest rates will keep financial conditions loose. But the Fed will not add significantly to liquidity.
The withdrawal of Fed support will be offset, many have assumed, by the European Central Bank (“ECB”) and Bank of Japan (“BoJ”). The ECB plans to expand its balance sheet by over $ 1 trillion over the next 18 months, through a mixture of purchases of Government Bonds, asset backed securities, and loans to Banks. Meanwhile, based on its current plans, the BoJ intends to purchase Japanese government bonds at an annual rate totaling more than $700 billion.
At 16% of gross domestic product, the Japanese program is much larger than the Fed’s QE measures, adjusted for relative size of the two economies. The balance sheets of the BoJ and ECB should expand by a total of a minimum of $2.5 trillion by the end of 2016 at current exchange rates. This is comparable to the $3.6 trillion expansion in the Fed’s balance sheet since 2008.
A wild card is the People’s Bank of China (“PBOC”), which is also loosening money supply. But this may be to merely mitigate the sharp tightening in liquidity resulting from the increasing controls on China’s Shadow Banking System, but there are differences between the liquidity programs. The Fed and BoJ primarily purchase government bonds, while the ECB also lends to Banks. The PBoC acts almost exclusively through the Banking System.
The crucial difference between the actions of individual Central Banks is that the ECB, BoJ or PBOC cannot directly supply the U.S Dollars crucial to Global Markets.The importance of Dollar Liquidity is driven by several factors. First, the Dollar DXY, +0.08% remains the most important Global Reserve Currency. The U.S Debt markets, at around $60 trillion, are the largest in the world — bigger than Europe and Japan combined.
Second, the U.S Dollar plays a crucial benchmark role, with a number of Currencies formally or de facto linked to the U.S Dollar. U.S. rates influence the pricing of assets Globally. Third, the largest amount of Foreign Currency Debt, especially that issued by emerging market borrowers, is denominated in U.S Dollars.
The Risk to Financial Stability and Global Asset Prices is rapidly increasing.
According to the Bank of International Settlements, as of the end September 2014, U.S. dollar credit to non-bank borrowers outside the U.S. totalled $9.2 trillion, comprising 46% debt securities and 54% bank loans. The total has increased over 50% since end-2009. Emerging market borrowers have borrowed $5.7 trillion in foreign currency, comprising $2.6 trillion in securities and$3.1 trillion in bank loans. Around 75% to 80% of this debt is estimated to be dollar denominated.
Cross-border borrowings, mostly in U.S Dollars, by Chinese Banks and companies have reached $1.1 trillion. It is around $450 billion for Brazil, $380 billion for Mexico and over $700 billion for Russia. It is unclear what proportion of these liabilities is protected against currency risk by U.S Dollar income or derivative hedges.
Tightening of available Dollar liquidity, a rising U.S Dollar and anticipated increases in U.S interest rates will result in losses on these borrowings. In turn, this will create repayment difficulties for over-indebted borrowers, triggering a new Financial Crisis. The risk is exacerbated by domestic weaknesses in many emerging markets, and low commodity prices compound the problems. It reduces the Dollar-denominated revenue available to meet Debt obligations of Exporters, increasing potential exposures to Currency fluctuations.
It also reduces Global Dollar liquidity. Since the first oil shock, Petrodollar recycling — the surplus revenues from oil exporters — has been an essential component of Global Capital Flows. A prolonged period of low prices will reduce available liquidity, pushing up the value of the Dollar and increasing interest costs, affecting the ability of borrowers to gain access to needed Dollars. In the first few months of 2015, for example, Saudi Arabia’s large foreign exchange reserves fell by an unprecedented 5%, consistent with tightening liquidity.
The position is eerily similar to 1997-98, when falling commodity prices, especially oil, a Stronger Dollar, Rising U.S Interest Rates and Emerging Market Debt and weaknesses led to the Asian Monetary Crisis, the Russian default, and the Collapse of hedge-fund Long Term Capital Management. Now as then, the risk to Financial Stability and Global Asset Prices is rapidly increasing.
Author: Satyajit Das is a former Banker and Author of “Extreme Money” and “Traders, Guns & Money.”