Friday, March 06, 2009

The US dollar's Vitality Stems From Debt Deflation Prompted US Dollar Shortage

We have long argued that the recent strength of the US dollar, which was seen almost across most major currencies, have been mainly a function of the US dollar's role as an international currency serve. [see latest Asian Currencies Fall On CEE To South Korean Won Contagion]

Apparently the Bank of International Settlements in its Quarterly Review has a similar perspective.

The chart according to the BIS "examines cross-currency funding, or the extent to which banks invest in one currency and fund in another. This requires a breakdown by currency of banks’ gross foreign positions, where positive (negative) positions represent foreign claims (liabilities).

``For some European banking systems, foreign claims are primarily denominated in the home country (or “domestic”) currency, representing intra-euro area crossborder positions (eg Belgian, Dutch, French and German banks). For others (eg Japanese, Swiss and UK banks), foreign claims are predominantly in foreign currencies, mainly US dollars. These foreign currency claims often exceed the extent of funding in the same currency. (bold emphasis mine)

So how did the shortage come about? From the unraveling debt deflation process...

Again from the BIS (bold emphasis mine),

``European banks’ funding pressures were compounded by instability in the non-bank sources of funds on which they had come to rely. Dollar money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks (see Baba et al in this issue). Less abruptly, a portion of the US dollarforeign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis. In particular, some monetary authorities in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars.

``Market conditions made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securities, other claims on non-bank entities – such as structured finance products – were harder to sell into illiquid markets without realising large losses. Other factors also hampered deleveraging of US dollar assets: prearranged credit commitments were drawn, and banks brought off-balance sheet vehicles back onto their balance sheets...

``The frequency of rollovers required to support European banks’ US dollar investments in non-banks thus became difficult to maintain as suppliers of funds withdrew from the market. The effective holding period of assets lengthened just as the maturity of funding shortened. This endogenous rise in maturity mismatch, difficult to hedge ex ante, generated the US dollar shortage."

Despite the tremendous amount of financing generated by the US Federal Reserve, the losses in the US banking system compounded by the pressures on the European Banking system has been far greater in reducing supply of US dollars in the global financial system. Nonetheless, all these reveals of the inherent privileges of the world's currency reserve.

In short, the factors of demand and supply of currencies dictate on relative currency values, with special emphasis over the short term, more than just economic conditions.

1 comment:

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