A decade ago, economic Cassandras saw the yawning US trade deficit and crumbling capital markets as reason to expect Armageddon for the dollar. When the crisis came, the opposite happened. They forgot the dollar’s role as international currency. The Bank for International Settlements has a neat phrase for the error — the “triple coincidence”. It is the assumption that a currency area coincides with a GDP area and a decision-making unit. With the dollar, the circles do not match but just loosely overlap. Far from US shores, people and businesses like to lend, borrow and transact in the greenback. So the world being a net lender to the US did not preclude there being non-US interests short of dollars, and desperately bidding for them when the crunch came.
Ten years on the greenback’s international role is still causing anomalies. Hyun Song Shin of BIS has drawn attention to another textbook-defying phenomenon: failures of covered interest parity. In brief, the interest rate derived from foreign exchange forwards is far from that available in cash money markets. You can buy the dollar against the yen three years forward at a 6 yen discount to the spot rate — at almost 2 per cent per year, that return is markedly higher than had you borrowed in yen and lent in dollars.
Such defiance of CIP is possible in part because the capital and funding that arbitrageurs (and textbook-writers) rely on have shrunk since 2007. But BIS also found a link with the global demand to hedge dollar positions, which has grown as US and non-US monetary stances have diverged. Investors chasing higher yields in the dollar area are one manifestation of this, as is how the ECB’s corporate bond-buying has attracted US issuance there. Both strategies require a swap into dollars.
BIS estimates dollar-denominated debt outside of the US at $9.7tn (for non-banks). A strengthening greenback tightens monetary conditions everywhere, but the Federal Reserve’s remit is domestic. Fed watchers pay close attention to US conditions. Dollar watchers need eyes everywhere else.
Email the Lex team at email@example.com
Sample the FT’s top stories for a week
You select the topic, we deliver the news.