Rise in cost of borrowing US dollars has implications for emerging market economies
The US dollar premium in foreign exchange swap markets has widened substantially
“The financial vulnerabilities in emerging market economies (EMEs) have not gone away,” the Bank for International Settlements (BIS) said on Friday, the same day solid US jobs data surely sealed the deal for the US Federal Reserve to raise interest rates next week.
Any rise in the cost of borrowing US dollars has implications for EMEs. There is a “stock of dollar-denominated debt, which has roughly doubled since early 2009 to over US$3 trillion,” the BIS said in its latest quarterly review.
As the world’s oldest international financial organisation, with 60 member central banks, the BIS is well-placed to make such calculations.
Turning first though to the US jobs data, non-farm payrolls rose 211,000 last month, data showed on Friday, while the figures for September and October data were revised up by an additional 35,000 jobs.
That was well above the 100,000 jobs a month needed “to simply provide jobs for those who are newly entering the labour force,” Fed chief Janet Yellen told Congress on Thursday.
Such nominally solid jobs data gives the Fed ample justification to raise rates this month.
An increase would also address the fear “that the Federal Reserve risks losing its credibility” through continuing delay, a concern voiced by Philadelphia Fed president Patrick Harker on Friday.
But markets have already anticipated the prospect of tighter US monetary policy at a time when the euro zone, Japan and other major economies remain in easing mode.
In Hong Kong, where the official home price index ended a 19-month rally in October, there is already a feeling among some analysts that an imminent rise in US interest rates will ultimately weigh on the price of local real estate.
More widely, the increased likelihood of global monetary policy divergence has already “rippled through global US dollar funding markets,” the BIS review said.
“Historically, cross-currency basis swap spreads – a measure of tensions in global funding markets – were virtually zero,” the BIS said but “since 2008, the basis has widened repeatedly in favour of the US dollar lender”.
That means a higher cost for borrowing in US dollars than in other currencies “even after hedging the corresponding foreign exchange risk.”
The US dollar premium in foreign exchange swap markets has widened substantially, in particular against the Japanese yen, after the odds of Fed tightening reached 70 per cent.
“At the end of November, the basis swap spread of the Japanese yen versus the US dollar was minus 90 basis points,” the BIS said.
That was “possibly reflecting in part the more than US$300 billion funding gap at Japanese banks,” the institution said, noting that, generally, “a large negative basis indicates potential market dislocations”.
There is no doubt that Japanese banks, seeking better returns overseas, have greatly expanded their non-yen denominated loan books in recent years and so would be among the earliest to experience the wider trend towards higher costs of US dollar funding.
They might also be expected to recognise the signs of the trend earlier too. Japanese financial institutions have past experience of having to “pay up” for US dollars, given the duration of Japan’s economic malaise.
US dollar credit has grown more rapidly outside the United States than inside since 2008, partly due, in the BIS review’s words to “its substitution for local currency credit given favourable dollar interest rates and exchange rate expectations”, although that “can leave borrowers vulnerable to rising
dollar yields and dollar appreciation”.
Chinese firms are not immune to these risks.
“To some extent, Chinese firms may have used the proceeds of dollar bonds to accumulate offshore [yuan],” the BIS said, decisions presumably predicated on the prospect of higher yields and a weaker greenback, neither of which now seem quite so certain.
Intriguingly “non-US borrowers owe remarkably little of their dollar debt to banks or investors that reside in the United States”, the BIS argued. “It is thus understandable that dollar credit to non-US residents has not, until recently, appeared on US radar screens.”
Nor may the Fed be particularly concerned. After all, the Fed might argue, no one forced anyone outside the US to pile into US dollar borrowings.
Emerging market holders of US dollar debt will no doubt be hoping that the Fed will increase rates once and be done, and that the rise in their debt service costs is already priced in.
With over US$3 trillion in US dollar-denominated debt, just in emerging market economies, that feels like wishful thinking.