Recent years have provided many striking illustrations of the we the centrality of the dollar in global financial markets. The shock to dollar funding markets in March 2020 sparked a global flight to safety, known as the “spot race,” which was only halted by unprecedented interventions by the Federal Reserve. Two years later, when Russia launched its invasion of Ukraine, investors nervously eyed the cross-currency base for signs that unrest might flare up again.
So far in 2022, brief surges from the base have not resulted in major dislocations. But the fact that investors have reached what was once a little-known and largely uninteresting financial indicator is the hallmark of two key developments. One is a seismic shift in the way global markets work since the 2008 financial crisis. Another is the groundbreaking work of Wenxin Du, one of the few economists whose research has shed light on the altered system in which the world currently lives.
Du is a leading financial economist at the Federal Reserve Bank of New York and an associate professor of finance at the University of Chicago Booth School of Business. His work in recent years has explored deviations from covered interest parity (C.I.P.), a classic relationship that banks should arbitrate any difference between the dollar interest rate in the spot market and the rate implied in foreign exchange markets. The cross-currency basis measures this difference, and it should be zero if C.I.P. is holding. Since the advent of Basel III capital agreement, however, the basis has tended to be slightly negative, implying that the synthetic dollar interest rate in the Effects swap market is higher than the spot rate.
“The cross-currency base emerged from an esoteric corner of the Effects derivatives market to become an important barometer of the health of global capital markets,” Du wrote with Jesse Schreger – himself a former recipient of central bank‘s Economics Award – in a working paper published in 2021.
The fundamental problem, as Du’s work shows, is that banks are now constrained by the Basel rules III leverage ratio, which sets a capital requirement for all exposures, including assumed risk-free arbitrage of cross-currency basis. This created a “balance sheet cost” for arbitrage and led to persistent deviations from C.I.P..
The discovery has major implications. Deviations from C.I.P. can mean big differences in funding costs around the world, both for sovereigns and for banks that don’t have direct access to the dollar spot market. The fact that deviations from C.I.P. increasing during times of stress implies that global banks with access to dollar liquidity do not necessarily pass it on to less fortunate counterparties. The reluctance of global banks to provide dollar liquidity necessitated the drastic actions of the Fed in March 2020, including the reopening of swap lines to several other central banks, the launch of an extensive quantitative easing program and, above all , relaxation of the leverage ratio constraint.
“My personal view is that we can handle stable small deviations from C.I.P.“says Du central bank. “However, we cannot guarantee a low and stable spread. The spread can become quite large and volatile at precisely the worst time.
Du reminded us how risk taking and leverage are essential ingredients in our understanding of international finance and the transmission channels of monetary policy
Hyun Song Shin, Bank for International Settlements
A trio of Du articles published as preprints in 2021 help trace the implications of the role of the dollar. The Working Paper with Schreger – forthcoming as a chapter of the textbook of international economics – so far tells the story of C.I.P. deviations and implications for global financial markets.
One of the issues raised by the paper is the need for a better model of the welfare implications of C.I.P. deviations. “The issue is much bigger than just write-offs because it really affects the long-term prospects of the dollar as the world’s reserve currency and the patterns of issuing dollar-denominated securities,” Du said.
But building a model is not easy. “We face significant data gaps in these markets,” she adds. “As part of ongoing work with the European Central Bank, we are looking in detail at the level of transactions to Effects swaps to see who is willing to pay more, whose demand is more inelastic.
A second article with Schreger, accepted for publication in The review of financial studiesshows how private sector foreign currency debt increases sovereign default risk, even as sovereigns have reduced their own reliance on dollar borrowing.
A third article, co-authored with Benjamin Hébert and Amy Huber, goes beyond the existing literature on C.I.P. deviations to explore the constraints that have led to the current state of affairs. The pricing of derivatives suggests that the risk of tighter constraints is being priced. The authors conclude that the result is “strongly supportive” of intermediate asset pricing theory, which states that large C.I.P. deviations are a sign that institutions are constrained.
“More broadly, we view this paper as the start of an investigation into the dynamics and pricing of arbitrages induced by regulatory constraints,” the authors state. “If intermediaries play a central role in both asset pricing and the broader economy, then the question of how to measure the constraints they face and the properties of those constraints is of primary importance.”
Hyun Song Shin, head of research at the Bank for International Settlements, says Du’s work has been “hugely influential” in political and academic circles.
“She highlighted the role of financial intermediation in financing and Effects markets, and reminded us how risk-taking and leverage are essential ingredients in our understanding of international finance and the transmission channels of monetary policy,” says Shin, who has collaborated with Du in the past.
Du is now exploring several other avenues of research. One is the role of non-banks in the dislocation of dollar markets. “A fascinating topic in this low yield environment is how institutional investors actually decide where to invest in terms of destination country and currency,” she says.
Another key area is the functioning of the Treasury market, which deteriorated in the March 2020 crisis. “In my view, a lot of these frictions, a lot of these bottlenecks and issues with Effects swaps and alimony markets also feed into the operation of the Treasury market,” Du says.
The role of non-banking financial intermediation and the structure of the Treasury market are now top priorities for regulators of the we and around the world. Du’s work is expected to continue to influence political debate for years to come.
The Central Banking Awards were written by Christopher Jeffery, Daniel Hinge, Dan Hardie, Victor Mendez-Barreira, Ben Margulies and Riley Steward