Dollar strength or dollar shortage?

by **Cals** Sat 15 Aug 2015, 16:38

Dollar strength or dollar shortage?

Saturday, 15 August 2015
By: DR SURESH RAMANATHAN

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THERE is no subtler, surer means of overturning the existing basis of society than to debauch the currency. Once a currency has been debauched or, to put it simply, destroyed, the worst thing one can do is prevent others from selling.
The past week has witnessed a cascading effect of tit-for-tat currency depreciation, following the People’s Bank of China’s move to re-engineer its fixing mechanism of the yuan.
The cost to this; a scramble by the rest of the Asian central banks to allow their respective currencies to weaken. At least, on this front, Bank Negara was ahead of the curve, letting the ringgit to weaken past 3.83 after intense defence even before the yuan devaluation took place.
But there is always two sides to the coin. Are Asian currencies weakening due to the strength of the US dollar, or is it because there is a shortage of US dollars in the local financial system?
For main street watchers, a lack of dollars would mean a trip to the bureau de exchange and being disappointed of having to pay a significant premium above screen prices for the US dollar, or worse still, of being told that they have run out of the greenback.
In the marketplace, how does one identify a dollar shortage?
Cross currency swaps are the instrument to be eyed. It is a foreign-exchange tool between two institutions to exchange the principal and/or interest payments of an underlying financial instrument in one currency for equivalent amounts in another currency. Cross currency swaps are motivated by comparative advantage, or in layman’s terms, fair exchange and no robbery!
For instance, a typical cross currency swap would involve two financial institutions – one with a ringgit exposure and a floating interest rate such as a three-month Klibor (Kuala Lumpur Interbank Offer Rate).
The other party has US dollars and a three-month Libor (London Interbank Offer Rate).
The transaction would involve exchanging interest payments (Klibor and Libor) or the ringgit and US dollar, or both with a specific contract. Usually, this involves long-term contracts of more than a year.
Cross currency swap facilitates the flow of dollars in and out of the system. It’s a hedging instrument for covering the cost of a trade in the onshore market by offshore traders, particularly when one purchases the underlying financial asset such as bonds.
It is also a tool that provides the ability to convert ringgit obtained from the sale of underlying financial instruments back to the US dollar.
A second feature of cross currency swaps involves the exchange of floating interest rates of two different currencies during the contract term, thus both the transactions should be valued at par and the difference (known as the “basis”) should be theoretically zero.
But in periods when perception about credit risk or supply and demand imbalances in markets increase the demand for the US dollar against another currency, then the cross currency swap “basis” can be negative, since a substantial premium is needed to convince an investor to exchange US dollars against a foreign currency.
As the “basis” declines and moves deeper into negative territory, it reflects a shortage of US dollars, pointing towards imbalances of dollar supply and demand in the system.
A number of factors induce this negative “basis” in cross currency swaps, namely, credit risk of counterparties in the transaction, creditworthiness of the local banking system, monetary policy divergence and finally, the dearth of US-dollar inflows.
Negative “basis” in cross currency swaps is not a phenomenon that affects only EMERGING economies, it has occurred in DEVELOPED economies as well. In the 1990s during the banking crisis in Japan, it caused a prologed negative “basis” in US dollar/Japanese yen cross currency swaps.
Similarly, the European debt crisis of 2010/2012 was associated with a sustained period of negative “basis” in euro/US dollar cross currency swaps.
In the current environment of emerging market currencies weakening, the negative “basis” has affected certain currencies more than the rest, particularly the ringgit, pointing towards a large degree of US dollar shortage in the system.
Given the cost of converting ringgit obtained from the sale of underlying financial instruments back to the US dollar is prohibitively high, it could erode the profitability of the trade.
This provides insights on why the percentage of Malaysian debt holdings by foreigners is still high even when the ringgit is at a 17-year low.
The next time one heads to the bureau de exchange and faces a US dollar shortage, bear in mind the cross currency swap basis and not just the US dollar strength. There is more to it than meets the eye!
Dr Suresh is an independent interest rate and foreign exchange strategist. He can be contacted at [You must be registered and logged in to see this link.].