When it comes to ensuring an ample supply of US dollars to the world, the Fed needs backup.
Or at least that’s the message one gets from IMF Managing Director Kristalina Georgieva, who told reporters the fund is pondering the establishment a vehicle to provide USD liquidity to countries without enough Treasury collateral to access the Fed’s foreign repo program.
Last week, the Fed unveiled the temporary facility with foreign central banks and international monetary authorities in order to put the brakes on the kind of mass Treasury liquidations witnessed in March, when market participants sold anything that wasn’t tied down in order to raise USD cash. Foreign central banks sold more than $100 billion in Treasurys over the stretch in a panicked bid to secure USDs amid the chaos.
Nearly 100 countries have asked the IMF for economic help as coronavirus lockdown measures threaten to plunge the world into the worst downturn in a century.
“Our board is going to review a proposal in the next days on creating a short-term liquidity line that is exactly targeted to countries with strong fundamentals, strong macroeconomic fundamentals, that may be experiencing short-term liquidity constraints”, Georgieva said, during an online briefing with the media. “We’re short of one instrument to provide short-term liquidity to countries that are basically strong but find themselves in a tight place”.
The Fed’s foreign repo facility, you’ll recall, is aimed at killing two birds with one stone. In addition to discouraging indiscriminate selling of Treasurys into a thin market, it’s designed to serve as an additional source of dollar liquidity and thereby compliment the swap lines which were enhanced as part of the raft of measures rolled out on March 15 and then expanded on March 19.
Although the Fed’s swap lines were extended last month to include Australia, Brazil, Denmark, Korea, Mexico, New Zealand, Norway, Singapore and Sweden (in addition to the standing arrangements with the BOC, the BOE, the BOJ, the ECB and the SNB), that’s just 14 central banks.
Apparently, oil exporting countries and smaller Asian economies were liquidating Treasurys in March, while central banks more generally were dumping their least liquid US debt, exacerbating last month’s dramatics (see here).
Hence the need for the Fed’s foreign central bank repo facility.
That the IMF is pondering a new, similar program, is a clear indication that the Fed’s actions may not be enough to supply sufficient dollar liquidity to a thirsty world.
The fund is acutely aware of the risks, and indeed spent a considerable amount of time discussing the potential knock-on effects of tightening dollar liquidity in last October’s Financial Stability Report.
“Beyond financial stress spillovers, cross-border lending is the main channel through which an increase in US dollar funding costs is transmitted from lenders to recipient economies”, the fund wrote, in one section of the report.
“A 50 basis point annual cumulative increase in US dollar funding costs is associated with a reduction in US dollar cross-border lending by 5.3% [and] this reduction is larger when the lender is an emerging market, amounting to a 7.1% decrease for all recipients and a 9.3% decrease in lending to other emerging markets”, the report goes on to say, adding that “emerging market recipients are more susceptible in general to cutbacks in cross-border lending when US dollar funding conditions tighten”.
In fact, the IMF’s data suggests that an increase in US dollar funding costs of 50 basis points hits USD lending to EM recipients by nearly -7%, or about twice the impact on advanced economy recipients (orange bar in the visual).
Of course, this is exacerbated by higher hard-currency debt burdens facilitated by years of favorable market conditions in the vaunted “hunt for yield” environment. According to the BIS, corporate borrowers globally are weighed down by growing piles of dollar-denominated debt.
“Emerging-market borrowers who tend to rely on the IMF for aid are particularly at risk of the lack of dollars”, Bloomberg writes, in their coverage of the IMF’s planned liquidity backup facility. “Encouraged by low US interest rates, they’ve loaded up on dollar-denominated debt in recent years [and] now face a squeeze as their exports plummet, with economies shutting down worldwide to combat the pandemic”.
This is a problem that Zoltan Pozsar addressed expediently when the COVID crisis first began to manifest in severe market turbulence outside of China.
In a classic note from early March, Pozsar outlined how the entire world could be transformed into a dollar deficit agent by the domino effects associated with the lockdowns in place to halt the spread of the virus. Here’s a straightforward hypothetical (which turned out not to be so “hypothetical” after all) Pozsar used on March 3:
Consider, for example, an Asian airline that stops having inflows due to reduced demand to fly to, from and across Asia. The initial positive impact on funding comes from the reduced demand for jet fuel – which is also mirrored in the reduced funding needs of commodity houses that would fund the sourcing and shipment of jet fuel for airlines – but the deficits accumulate over time from keeping pilots and cabin crews on payroll, paying the rent on parking spots and gates at hundreds of airports the world over, and servicing the debt that finances the fleet of aircrafts. The longer passengers don’t fly, the longer the planes are grounded, and the more the airline’s dollar deposits are depleted: the airline gradually becomes a deficit agent, like chipmakers. Hotels are next…
That’s when it gets really dicey. Because at that point, as firms run down their dollar balances and look to borrow dollar funding, banks themselves come under strain. Then, the pressure starts to build in the interbank market.
Pozsar went on to explain how the ripple effect would play out. To wit, from the same note:
A flood of corporate drawdowns could force the entire banking system into becoming a deficit agent – the extreme example of the outbreak infecting the top of the hierarchy: from firms to individual banks, to country level banking systems, to financial centers and, as contagion spreads and turns the global banking system into a deficit system, to the Fed – the only entity that can serve as a surplus agent to match the needs of a deficit system.
This all gives you a sense of how we got to where we are and why it feels like the Fed (and now the IMF) are playing a nightmarish game of of “Whac-a-Mole” when it comes to making sure the flow of dollars to the world is ample.
In many ways, this is the “classic” EM problem (i.e., “What happens when the hot money flows reverse?”), but the same caveat that applies to virtually everything else right now applies here too. That is, while it is true that excesses which accumulated during the post-crisis years are now being exposed, the nature of the trigger (a pandemic and the simultaneous, engineered shutdown of the entire global economy) is unique, and requires a commensurate policy response.
Of course, any IMF swap program would put the fund itself on the hook, and there’s something wholly contradictory about the idea of making any such facility available primarily “to countries with strong fundamentals”, as Georgieva put it late last week. In spirit, that’s akin to making unemployment benefits contingent on proof of steady employment.
To be fair, I suppose there are plenty of fundamentally sound (from a macro perspective) economies that don’t enjoy the luxury of a large Treasury stash they can liquidate in the market or repo at the Fed to raise dollars which can then be lent on to the local economy. In other words, I suppose there are lots of legitimate candidates for the envisioned IMF facility.
At the end of the day, it’s just another sign that while the Fed has succeeded in reducing the risk of a catastrophic, near-term, global dollar-funding crunch, the world’s thirst for USDs is far from sated.