I think we should distinguish between dollar shortage and dollar funding stress. We have a lot of the latter and much less of the former compared to any previous crisis.
‘Dollar shortage’ is your classical EM currency crisis stemming from a balance sheet currency mismatch: borrow in dollars to fund a non-dollar asset. Cue Mexico’94, Asia’97, Russia’98, Brazil’99, Turkey’01, Argentina’01. There are fewer of them nowadays.
A ‘dollar funding stress’ stems from borrowing in dollars to fund a dollar asset – that’s the problem today (see for ex. Z. Pozsar’s latest). It feels like the old EM currency crises because a lot of dollar assets are owned by foreigners but it is very different at the same time as there are no balance sheet currency mismatches.
That distinction is important because the market is treating it as if it is a dollar shortage crisis while it is a classic ‘Mark-to-market (MTM)’ crisis. If the dollars were borrowed through the swap market, refinancing would widen the basis and move the currency. If the borrowing was in the loan/bond market, it would be a credit story, not a currency story.
There is also a break even price for dollar funding above which foreigners would choose to sell the dollar asset and repay the loan, rather than continue to finance it (probably they will have to top up if the MTM has moved too much from where they bought it). All this is a very different situation from a dollar shortage crisis whereby they would need to sell a local currency asset and actually convert proceeds into dollars.
The Fed is well aware of all this and has acted very swiftly to respond to the recent strengthening of the dollar by improving massively the terms of the five existing central bank swap lines and by adding today nine more to the frame. The extraordinary moves in some DM currencies, notably NOK and AUD, has also prompted the respective central banks to verbally intervene (Norges) or ‘not to rule out’ intervention (RBA).
Some people have mentioned to me that a new Plaza Accord is needed. I am not so sure. In my opinion, it would be counterproductive. From a behavioral point of view, a weak dollar is not necessarily beneficial for US assets given that a big chunk of them is owned by foreigners. Just like a worsening of the dollar funding terms may push these people to sell, so could an attempt to substantially weaken the dollar. We shouldn’t forget a small but very much overlooked fact of the 1987 stock market crash: on the weekend before Black Monday, the US Treasury Secretary threatened to devalue the dollar.
Bottom line is that a dollar funding crisis should have a much smaller effect on weakening the local currency than a dollar shortage crisis. The market does not need a dollar devaluation, rather a stable dollar. Policy makers should make sure foreign dollar funding does not blow up. And finally, market pundits should be careful exaggerating the dollar shortage issue.
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