Dollar strength is a deadweight for the global economy

By Zac Tate, Hottinger Investment Management

There is a statistic hidden in a report for the Bank for International Settlements (BIS) that is a little surprising.

According to the World Trade Organisation, not only does some 80% to 90% of world trade rely on some form of trade finance (trade credit, insurance or guarantees), though mostly of a short-term nature; research from the BIS’s Committee on Global Financial Services found that up to 80% of this is denominated in dollars. Whilst firms finance most global trade (65%) themselves, either by the seller in the form of “open account financing” or by the buyer paying upfront in a “cash-in-advance” purchase, the banking system underwrites the rest – a sizeable 35%.

This means that not only the value of the dollar, but also the state of dollar financing conditions, matter well beyond US borders. In recent months, despite intentions having been signalled by central banks since late last year to start to ease monetary conditions, there are signs that the opposite is happening. Bloomberg’s index of dollar financing conditions has flirted with contraction since August.

What does this mean? The Bloomberg U.S. Financial Conditions Index1 tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.

Figure 1 shows broad US financial conditions in an index that expresses whether the availability and cost of finance is becoming more generous (if the index is above zero) or less (if the index is below zero).

The availability of credit is arguably as important as the cost of credit, and the two are interlinked. We can see some signs of this by looking at the dollar’s cross currency basis (XCB) with major developed market (DM) and emerging market (EM) currency pairs. As the chart below shows, the dollar XCB is currently strongly negative against the euro, yen, Korean won and Turkish lira. The dollar XCB is positive with some currencies such as the Mexican peso and the British pound, but on balance it is broadly negative. Any ‘basis’ – positive or negative – should not be possible; the theory of covered interest parity means that there should not be a difference between the own-currency interest expense that a foreigner pays on her dollar borrowings and what they would pay if borrowing the same funds in their own currency for the same period of time. A negative basis means that foreigners are effectively paying a premium to borrow dollars in the swap market and this typically arises when there is excess demand for dollars in the global system.

Figure 2 shows the dollar cross currency basis with the euro, Korean won, Turkish lira and Japanese yen for transactions with a range of maturities (1-year, 3-years, 5-years and 10-years).

The Federal Reserve and US banks are essential suppliers of dollars, and it is more than possible that the Fed’s hiking cycle, which began with the tapering of QE in late 2013, has squeezed global liquidity.

Figure 3 shows the evolution of US base interest rates since 1984. In the late 2000s, the Federal Funds Rate – the rate at which commercial banks can borrow reserves from the Federal Reserve – hit its zero lower bound (0%), after which the central bank used Quantitative Easing (QE) to ease financial conditions further. The Wu-Xia Shadow Interest Rate measures the effective US base interest rate after taking into account operations taken under various QE programmes, including the reversal of QE, which began in 2013.

Compounding the problem is the persistent strength of the US dollar, which few analysts expected this year as they made bets on the recovery of emerging markets. The combined effect of higher US interest rates, the growing importance of the dollar in global trade and the role of American markets as safe havens during times of economic stress has kept the dollar strong. Since early 2018, the Indonesia rupiah (-3%), the Taiwanese dollar (-7%), the Indian rupee (-10%), the Chinese yuan (-12%), the Korean won (-12%) and the Brazilian real (-20%) have all weakened substantially against the dollar.

It is not surprising, therefore, that global trade is in the doldrums. Policy uncertainty no doubt has had a role to play, but we cannot underplay the effect of tightening dollar financing conditions, the restricted supply of the dollar and the increasing reliance of international business on the greenback.

1All of the indicators included in the composite BFCIUS index are normalized by subtracting the mean and dividing by the standard deviation for each series. The mean and standard deviation are calculated from observations during the pre-crisis period, which is defined as the period from 1994 to July 1, 2008. The normalized values are then combined into the composite BFCIUS index, which is itself normalized relative to its pre-crisis values. As such, the BFCIUS index is a Z-Score that indicates the number of standard deviations by which current financial conditions deviate from normal (pre-crisis) levels.