Global currency mismatches threaten us all
When funding conditions turn, relying on cheap dollars to finance local assets can be lethal
The indication by the US Federal Reserve that it was considering a reduction in the rate at which it would expand its balance sheet had a dramatic effect on emerging economies
The most sobering lesson of the global financial crisis was that developments expected to increase resilience – the “originate and distribute” model of finance – turned out to reduce it.
Does a similar danger now threaten stability? Yes. The next round of global illiquidity might derive from foreign currency bonds of non-financial companies of emerging economies. The centre would be asset managers, not banks.
Last summer’s “taper tantrum” was a foretaste. The indication by the US Federal Reserve that it was considering a reduction in the rate at which it would expand its balance sheet had a dramatic effect on emerging economies. As the International Monetary Fund noted in its October world economic outlook: “Expectations for earlier US monetary policy tightening and slowing growth in emerging market economies prompted major capital outflows from emerging markets during June 2013.” The results included a widening of risk spreads, equity market falls and big declines in exchange rates against the dollar.
Why did turmoil follow the mere possibility of a tightening in Fed monetary policy? At a conference on Asia at the Federal Reserve Bank of San Francisco, Hyun Song Shin of Princeton University, among the world’s foremost financial economists, suggested an answer: the growth of demand for the private sector bonds of emerging economies.
In booms, finance floods the market, driving excesses; in busts, finance dries up, causing slumps. This phenomenon is known by the loose term “global liquidity”. Before the global financial crisis, banks were the main providers of liquidity. Since 2010, a locus has been the bond finance of non-financial corporate sectors of emerging economies. Asset managers (BlackRock, Vanguard, Fidelity, Pimco and so forth) drive the flows. This, then, is the “second phase of global liquidity”. It is also why portfolio flows to emerging economies reversed last summer.
External finance of emerging economies has changed in two ways: non-banks have become bigger borrowers, relative to banks; and debt securities have largely replaced loans. Much borrowing is done abroad. An indication is the widening gap between borrowing by place of residence and by nationality: Chinese companies, for example, issue foreign currency bonds in Hong Kong, not the mainland.
The purchasers of these bonds search for yield in a low-yield world by lending longer and riskier. Borrowers take advantage of the lower cost of foreign-currency bonds. But in the process, they assume a currency mismatch: foreign currency debt against domestic currency assets. These borrowers are speculating on their domestic currencies. Students of the Asian financial crisis of 1997-98 will find this disturbingly familiar. Non-financial companies have taken on a “carry trade”, by financing local assets with apparently cheap dollars.
When funding conditions turn, such trades can become lethal. As the Fed is expected to tighten, the dollar will rise, prices of dollar bonds will fall and dollar funding will reverse. As the bonds they issued lose value, borrowers will be forced to post more domestic currency as collateral. That will squeeze their cash flows and trigger a downturn in corporate spending. A fall in the exchange rate will exacerbate the squeeze upon them. Highly indebted non-financial corporations may even go bankrupt, imperilling domestic creditors, including the banks.