BIS warns of further pressure on financial system from monetary policy in Japan and Europe
A stronger US dollar is straining the global financial system,
the Bank for International Settlements said on Tuesday, as it warned
that aggressive monetary policy in Japan and Europe could herald further
pressure.
Foreign investors flooded into US markets as central banks responded to the 2008 financial crisis with accommodative monetary policies, beginning a boom in corporate bond issuance. The weak dollar at the time made it easy for foreigners to convert or “hedge” this borrowing back into local currencies.
But as US monetary policy has tightened and the dollar has strengthened, the cost of hedging US borrowing has risen, amplified by divergent monetary policy from other global central banks such as Europe and Japan.
Hyun Song Shin, head of research at the BIS — a global regulatory organisation made up of representatives from the world’s major central banks — said that this had led to a breakdown in financial markets, with indicators of stress flashing red.
“The key takeaway is that a stronger dollar is associated with more severe market anomalies,” Mr Shin told a World Bank conference in Washington DC.
The DXY dollar index has gained over 30 per cent since its 2008 low but has weakened 4.8 per cent this year, leading some analysts to suggest that the currency’s bull-run is fizzling out.
The amount of US dollar-denominated debt of non-banks outside the US currently stands at $9.7tn. Of this, the US dollar-denominated debt of non-banks in emerging markets stands at $3.3tn.
“There is no room for complacency … Dollar borrowing will spill over into the rest of the economy in the form of easier credit conditions,” said Mr Shin. “When the dollar borrowing is reversed, these easier domestic financial conditions will be reversed, too.”
Mr Shin highlighted an indicator called “covered interest parity”, which is the relationship between the interest rate implied by foreign exchange markets and other market interest rates such as US dollar Libor, a major international benchmark. In theory, the two should be the same because any divergence would allow someone to lend at the higher rate and borrow at the lower rate.
“Before 2008, CIP held as an empirical regularity with very few exceptions worth mentioning,” he said. “As an academic, I used to tell my students that CIP is about the only relationship that can be relied upon in international finance. I know better than to say this now.”
Mr Shin added that aggressive monetary policy in Europe and Japan was showing signs of creating a similar effect to that seen in the US, as foreign companies flock to borrow money at low interest rates.
“As the euro and yen join the dollar in the ranks of international funding currencies, we are left with a dilemma,” he said. “With each successive wave of monetary easing since the financial crisis, greater demands are being made on international capital markets.”
Foreign investors flooded into US markets as central banks responded to the 2008 financial crisis with accommodative monetary policies, beginning a boom in corporate bond issuance. The weak dollar at the time made it easy for foreigners to convert or “hedge” this borrowing back into local currencies.
But as US monetary policy has tightened and the dollar has strengthened, the cost of hedging US borrowing has risen, amplified by divergent monetary policy from other global central banks such as Europe and Japan.
Hyun Song Shin, head of research at the BIS — a global regulatory organisation made up of representatives from the world’s major central banks — said that this had led to a breakdown in financial markets, with indicators of stress flashing red.
“The key takeaway is that a stronger dollar is associated with more severe market anomalies,” Mr Shin told a World Bank conference in Washington DC.
The DXY dollar index has gained over 30 per cent since its 2008 low but has weakened 4.8 per cent this year, leading some analysts to suggest that the currency’s bull-run is fizzling out.
The amount of US dollar-denominated debt of non-banks outside the US currently stands at $9.7tn. Of this, the US dollar-denominated debt of non-banks in emerging markets stands at $3.3tn.
“There is no room for complacency … Dollar borrowing will spill over into the rest of the economy in the form of easier credit conditions,” said Mr Shin. “When the dollar borrowing is reversed, these easier domestic financial conditions will be reversed, too.”
Mr Shin highlighted an indicator called “covered interest parity”, which is the relationship between the interest rate implied by foreign exchange markets and other market interest rates such as US dollar Libor, a major international benchmark. In theory, the two should be the same because any divergence would allow someone to lend at the higher rate and borrow at the lower rate.
Mr Shin said that since the crisis these rates have consistently diverged, with a particular widening in the past 18 months as the dollar has strengthened.There is no room for complacency … Dollar borrowing will spill over into the rest of the economy in the form of easier credit conditions
“Before 2008, CIP held as an empirical regularity with very few exceptions worth mentioning,” he said. “As an academic, I used to tell my students that CIP is about the only relationship that can be relied upon in international finance. I know better than to say this now.”
Mr Shin added that aggressive monetary policy in Europe and Japan was showing signs of creating a similar effect to that seen in the US, as foreign companies flock to borrow money at low interest rates.
“As the euro and yen join the dollar in the ranks of international funding currencies, we are left with a dilemma,” he said. “With each successive wave of monetary easing since the financial crisis, greater demands are being made on international capital markets.”
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