A dollar shortage is a state of FX and rates markets where covered interest rate parity between the U.S. and another currency area would result in excess dollar demand. Covered interest rate parity is the equality for short-term interest rate differentials and FX forward implied carry. Since the great financial crisis, arbitrage between onshore and offshore dollar credit markets through FX swaps has been impaired. In contrast, the dollar’s dominance in international transactions has remained intact. The consequence of market segmentation and dollar dominance has been sporadic dollar shortfalls in times of market turmoil or tightening financial conditions: a rush for liquidity turns into a net “dash for dollars,” and dollar rates in the offshore market rise above those in the onshore markets. Since higher dollar rates in the offshore market drive both offshore borrowers and lenders to buy dollars in the FX spot market directly, the dollar appreciates, at least temporarily.
Bacchetta, Philippe, Scott Davis, and Eric van Wincoop (2023), “Dollar Shortages, CIP Deviations, and the Safe Haven Role of the Dollar.”
Becker, Jonas, Maik Schmeling and Andreas Schrimpf (2024), „Global Bank Lending and Exchange Rates.”
Below are quotes from the papers. Emphasis, cursive text, and text in brackets have been added for clarity.
This post ties in with SRSV’s summary of implicit subsidies in financial markets, particularly the section on foreign exchange.
The segmentation of dollar markets since 2007
“Prior to the Global Financial Crisis, the US dollar funding market was globally integrated, driven by effective international arbitrage…Balance sheet constraints have limited arbitrage since then, in part due to new leverage regulations. This means that the offshore markets may not clear at the same interest rate as the onshore markets…This segmentation is reflected in persistent cross-currency basis spreads or deviations from covered interest rate parity (CIP). In periods of heightened financial stress, offshore dollar funding markets experience dollar shortages that are associated with an increase in CIP deviations.” [Bachetta, Davis and van Wincoop]
“At the heart of this intermediation process are globally active banks. Not only do these financial institutions intermediate global portfolio flows in capital markets through their broker-dealer arms, but they are also crucial for supplying cross-currency loans to financial and non-financial borrowers. In all of these financial transactions, the US dollar (USD) stands out given its special role in the global financial system.” [Becker, Schmeling, and Schrimpf]
“On the one hand, there has been an increase in the demand for dollar swaps, in particular by foreign international institutional investors holding dollar assets. On the other hand, the supply of dollar swaps by global banks (CIP arbitrageurs) has been more limited due to the new leverage regulations since the Global Financial Crisis.” [Bachetta, Davis and van Wincoop]
“We show that the impact of lending flows on exchange rates only emerged after the Global Financial Crisis and that it is stronger when dealers’ capacity to flexibly expand their balance sheet by taking on greater leverage is more constrained. It is also stronger when funding conditions in the US dollar tighten, e.g., during the hiking phase of the monetary policy cycle or when USD reserve holdings in the banking system are more concentrated. All in all, these findings point to an important role for intermediation and funding frictions in affecting exchange rates.” [Becker, Schmeling, and Schrimpf]
“Markets are segmented in the sense that [for dollar and euro] there is an onshore and an offshore [credit] market, and there may be imperfect arbitrage between the two. Global financial intermediaries, referred to as CIP arbitrageurs, are the only agents that arbitrage between onshore and offshore markets…Global CIP arbitrageurs borrow dollars in the onshore US market and lend synthetic dollars to Europe… In a frictionless world, arbitrage is perfect, so that onshore and offshore rates are equal.” [Bachetta, Davis and van Wincoop]
A model for understanding segmented markets
“We think of the Home country as the US and the Foreign country as the rest of the world. For convenience we will often refer to the latter as Europe and the currency as the euro… [The figure below] presents a flow diagram that includes the agents and financial markets in the model. It shows how funds flow from lenders at the top of the diagram through financial markets in the middle to borrowers at the bottom.” [Bachetta, Davis and van Wincoop]
“In Europe there is an onshore euro market and an offshore dollar market. Offshore borrowing and lending can happen both through offshore bonds and through synthetic funding. For example, a European borrower can issue a dollar bond or borrow dollars synthetically by issuing a euro bond and then using the swap market to swap it into dollars. [The figure above] shows that synthetic borrowing and lending is connected to the swap market.” [Bachetta, Davis and van Wincoop]
“Only CIP arbitrageurs arbitrage between US and European markets. With a positive CIP deviation, they wish to borrow dollars in the onshore US market and lend synthetic dollars to Europe.” [Bachetta, Davis and van Wincoop]
“Various institutions that can be thought of as the real world counterparts to the borrowers and lenders in the model. For example, non-US institutional investors often invest in US onshore assets, while swapping part of it back into their own currencies. This corresponds to foreign lenders in the model. Foreign corporations that issue dollar bonds outside the US are an example of domestic borrowers.” [Bachetta, Davis and van Wincoop]
“The model will be solved from two equilibrium conditions, for the spot and swap FX markets. The spot market equilibrium refers to the pure spot market, separate from the spot component of swap transactions…These two equilibrium conditions will determine the spot [exchange rate] rate and the swap rate [or synthetic dollar or euro interest rate].” [Bachetta, Davis and van Wincoop]
Definition of dollar shortages in the offshore market
“There is a dollar shortage when there is an excess demand for dollar swaps with a zero CIP deviation. This happens when the net demand for synthetic offshore dollar funding (borrowing minus lending) is higher than the net demand for offshore euro funding. This raises the offshore dollar interest rate, leading to a positive CIP deviation. Therefore, CIP deviations [also called dollar basis] are an indicator of dollar shortages.” [Bachetta, Davis and van Wincoop]
The causes of dollar shortages in the offshore market
“In an environment where the dollar is so widely used, dollar shortages can easily develop when global credit declines…Asymmetries between the US and the rest of the world can cause both persistent and fluctuating dollar shortages…One such asymmetry is dollar dominance…Dollar dominance in trade implies higher dollar money balances in Europe than euro balances in the US, leading to higher foreign currency exposure in Europe than the US. Hedging foreign currency exposure leads to larger foreign currency borrowing and lower foreign currency lending. This leads to a greater excess demand for offshore dollar funding than offshore euro funding, giving rise to a dollar shortage.” [Bachetta, Davis and van Wincoop]
“A flight to liquidity is common during periods of increased financial stress…(a “dash for cash”). With dollar dominance, this implies a larger increase in the demand for dollar money (a “dash for dollars”)…The dash for dollars leads to a dollar shortage as it is associated with increased dollar borrowing and reduced dollar lending in the offshore dollar market. The resulting higher net synthetic dollar borrowing raises the synthetic dollar rate. The higher synthetic dollar interest rate raises offshore dollar lending and lowers offshore dollar borrowing. For both lenders and borrowers, this reduces their dollar money balances below desired levels. This leads to an increased demand for dollars in the spot market, causing the dollar to appreciate. [Bachetta, Davis and van Wincoop]”
The link between offshore USD lending and dollar shortages
“The offshore dollar market is composed of both direct and synthetic dollar lending and borrowing. Synthetic dollar borrowing implies borrowing euros and swapping them into dollars by buying dollar swaps. The buyer of a dollar swap exchanges euros for dollars at the current spot exchange rate and sells these dollars in exchange for euros next period at the forward rate. Similarly, synthetic euro borrowing in the offshore euro market in the US leads to sales of dollar swaps.” [Bachetta, Davis and van Wincoop]
The consequences of dollar shortages for covered interest rate parity
“The dollar spot and forward exchange rates are denoted S[t] and F[t]. These are dollars per euro… The synthetic dollar rate (plus 1) is then equal to F[t]/S[t], which is the swap rate SR[t] in the swap market. Analogously, the synthetic euro rate (plus 1) is the inverse of the swap rate…Excess demand for dollar swaps at a zero CIP deviation…leads to a rise in the swap rate, which implies a higher offshore dollar interest rate.” [Bachetta, Davis and van Wincoop]
The consequences of dollar shortages for exchange rates
“Conditions in the offshore dollar funding market affect the swap market and can lead to changes in both the CIP deviation and exchange rate. In a fully integrated global dollar market, an appreciation of the dollar can be explained by an increase in the global demand for dollar assets. With segmented markets, shocks to offshore dollar funding affect the dollar exchange rate, even with no change in the global demand of dollar assets.” [Bachetta, Davis and van Wincoop]
“A higher offshore dollar rate, in turn, leads to a dollar appreciation. Borrowers and lenders both need dollars, for example, to hold desired dollar money balances, pay for imports invoiced in dollars, repay dollar debt from the previous period, or make new dollar loans. Borrowers can acquire these dollars either by borrowing or buying them on the spot market. A higher cost of dollar borrowing leads borrowers to buy more dollars on the spot market, causing an appreciation. Lenders wish to lend more dollars when the offshore dollar interest rate rises. To be able to do so, [lenders] need to buy more dollars on the spot market, also causing a dollar appreciation.” [Bachetta, Davis and van Wincoop]
“We find a statistically significant and economically large effect of cross-currency lending flows on exchange rates…When non-US banks extend more loans in US dollars (USD) relative to US banks originating foreign currency-denominated loans, the USD appreciates significantly…When a foreign bank grants a cross-currency USD loan, it needs to obtain USD liquidity, which puts pressure on funding markets and leads to an appreciation of the USD. This effect – which we estimate via a granular instrumental variable approach – has greatly intensified since the global financial crisis and crucially depends on how banks fund the provision of cross-currency loans.” [Becker, Schmeling, and Schrimpf]
The antidote to dollar shortages: swap lines
“When CIP arbitrage is limited, it can be substituted by central bank swap lines. Beginning with the GFC, the Fed set up swap lines with the major foreign central banks exactly to provide offshore dollar lending. Thus, an excess demand for dollars in Europe can be met by the Fed, rather than through CIP arbitrageurs and the swap market.” [Bachetta, Davis and van Wincoop]
