BIS Quarterly Report Shows China's Swap Lines Misunderstood

The quarterly report by the Bank for International Settlements does not say it in so many words, but its warning of possible currency and funding mismatches illustrates why the much ballyhooed Chinese swap lines are misunderstood. 

Recall that during worst of the Great Financial Crisis in 2008-2009, there was no G7 currency intervention.  Instead, officials recognized the main problem was not foreign exchange prices per se, but the access to dollar funding.  The Federal Reserve responded accordingly and established currency swap lines with a several countries, to make dollar funding available, through national central banks.  These swap lines were used to varying degrees.  The swap lines for the ECB, BOJ, BOE, BOC, and SNB were converted into permanent structures of the global architecture in the form of standby agreements at the end of 2013.   Although the swap lines, and now standby agreements, were bilateral, the US never used the facility. 

Chinese officials saw the US swap lines and erroneously thought this was part of the US efforts to reimpose a dollar-centric order.  They responded by extending their own network of currency swap agreements.  Barring a single exception, they have not been drawn upon.  Yet, it has not prevented observers from claiming they represent the internationalization of the yuan.  

In the BIS quarterly report released over the weekend,  officials warn that a continued appreciation of the dollar will squeeze many corporations from emerging market economies.  There are two channels by which this will happen.  First, many of these businesses issued bonds denominated in foreign currencies, especially US dollars.  The BIS estimates such entities had issued $2.6 trillion of such obligations, of which three-quarters were denominated in US dollars.  Second, international banks have lent about $3.1 trillion as of mid-2014, mainly in dollars. to such companies. 

Borio, the head of the monetary and economic department of the BIS, was quoted on the news wires saying that "Should the US dollar, the dominant international currency, continue its ascent, this could expose currency and funding mismatches by raising debt burdens.  The corresponding tightening of financial conditions could only worsen once interest rates in the US normalize."

Moreover, an increase in foreign currency borrowing  proceeded the Latin American debt crisis of the late 1970s and early 1980s.  It presaged Mexico's Tequila Crisis in 1994-1995. An increase in  hard currency borrowing also took place in the run-up to the Asian financial crisis in 1997-1998.  

According to the BIS data, overseas lending rose by 400 bln in Q2 2014 to surpass $30 trillion.  The 1.2% increase in the year from mid-2013 was the first increase since the late-2011.  Far from being part of the solution (through the internationalization of the yuan), China is part of the problem.  BIS figures indicate that outstanding loans by international banks to Chinese businesses doubled in the 18 months to mid-2014 to $1.1 trillion.   

The low level of US interest rates, and the dirty peg that keeps the yuan shadowing the US dollar, made it attractive for Chinese companies to borrow dollars.    The currency mismatch may not be as large as it is for companies from other emerging market economies with a freer exchange rate regime.  However, the 3.8% dollar appreciation of against the yuan in first four months of this year was sufficient to wipe out more than a year of the interest rate savings.   Even now, the dollar is about 2% higher against the yuan than it began the year.  The difference between the US and China's prime rate is about 225 bp annualized.  

The fact that fixed exchange regimes have largely been jettisoned (with the notable exception of Hong Kong and OPEC countries), the risk of a repeat of the earlier emerging market crises are perceived to have lessened.   The more flexibly currency regime does not prevent the kind of currency mismatch that has led to past crises.    It is true that many emerging market economies have amassed large reserves of hard currencies.  These reserves can be employed to resist a currency decline or address a market imbalance.  Precisely how they can be used for a private sector currency or funding mismatch is less immediately clear. 

What the various crises over the past 40 years or so have in common is a currency or maturity mismatch that was accelerated just prior to the onset of the crisis.    The  low US interest rates relative to domestic rates available in emerging market economies, and the depreciation of the dollar, which was widely seen in structural rather the cyclical terms, encouraged such behavior.    It worked until the dollar and US interest rates rose.  

Many observers put the onus on the Federal Reserve.  When it eased policy using orthodox, and then unorthodox, policies to avoid a harder downturn, critics say it should not have done so.  It was exporting deflation.   As it prepared investors for the end of its unorthodox measures, some have complained the US is exporting inflation.  

  

The Federal Reserve is not the central bank for the world, but of the United States.  Still, it recognizes its importance.  It had revealed its intentions to investors months before it was going to slow its asset purchases.  It even waited a few months after it had appeared to signal the beginning of its tapering.    It has been warning investors since the beginning of the year that for after unspecified “considerable period”  upon the conclusion of its asset purchases, it would raise US interest rates.  The clearest signal from the Fed’s leadership is that this process will  likely begin around the middle of next year.  Of course, it is dependent on the data but barring a significant surprise,  those with potential funding or currency mismatches, have as much warning as can reasonably be expected that short-term US interest rates will rise.     

Meanwhile, China’s yuan swap lines go unused.  The yuan may be a lot of things, but it is not an international funding currency.