Inspired by the recent yen kerfuffle, in which the G7 central banks intervened to take the opposite side of the speculators’ trade that was driving up the yen, let’s try to connect some dots on the way to drawing a picture of the monetary side of financial globalization.
First big dot, global imbalances. The big story is of course the Chinese trade surplus, and its counterpart the US trade deficit. For our purposes, more important is the mirror image of these trade imbalances in capital flows, meaning foreign asset accumulation in China and foreign borrowing in the US.
The trade balance is multilateral but crucially the financial balance is less so, given Chinese preference to accumulate disproportionately Treasury and GSE assets. That means that the decision to bail out Fannie and Freddie was in part a geo-political decision to avoid forcing losses onto China. It follows that reform of US housing finance will only be done when there is sufficient explicit government backstop that China is once again willing to fund US mortgages.
Second big dot, cross-border banking. To simplify tremendously, think of global banks lending in dollars outside the US, and funding these loans with wholesale dollar borrowing in world markets. And think of the recipients of these loans as domestic banks in emerging economies, which borrow in dollars and lend in the domestic currency. In the crisis, both the global and domestic pieces of this “dollar supply chain” faced difficulties rolling their funding.
Global banks relied on their own private branches inside the US to get access to wholesale dollar funding, which turned out in the crisis to mean reliance on Fed backstop of dollar funding markets. Emerging economy banks relied on their own “self-insurance” reserve balances, but that turned out still to mean reliance on sovereign backstop and access to IMF funding, since reserve balances were not so easy to tap in the crisis; central bank liquidity swap lines at the Fed also came into play, for the very first time.
With the exception of the swap lines, all of these mechanisms had been developed in prior crises and, though the present crisis sorely tested them, they coped rather well. The global character of the global financial crisis did not come, as it was feared it would, from contagion to emerging market economies.
Third big dot, shadow banking. As a consequence of Chinese portfolio preferences, the rest of the world had to accumulate disproportionately private dollar assets, specifically mortgage backed securities. But their own portfolio preferences called for safe and liquid, as well as dollar, assets. They were accustomed, after all, to funding the existing cross-border banking mechanism, which involved holding Eurodollar deposits or dollar-denominated money market mutual fund shares.
The familiar cross-border banking dollar supply chain could have worked if only the global banks had been willing to hold mortgage backed securities directly, or to provide funding for others who would. Some of this did happen (think UBS) but not enough to get the job done. Enter shadow banking, which used the mortgages, or more specifically their AAA-derivatives, as collateral to tap the wholesale money market directly.
In this way of thinking, shadow banking was an evolution of cross-border banking, insofar as it relied heavily on the dollar supply chain that had been forged by the global banks. The difference was that the lending was in dollars to US borrowers, and securitization made it possible to move much of the lending off balance sheet.
That difference was crucial. Whereas in standard cross-border banking, emerging market banks could turn to local sovereign backstop and thence to the IMF, shadow banks had no country. They were reliant on world funding markets and so, in the crisis, they got squeezed out. Dumping of collateral was the significant mechanism for global contagion in this crisis, contagion from short term funding markets to long-term security markets, and thence throughout the world.
Fourth big dot, the dollar. Demand for dollar balances is only recently coming to be adequately appreciated as a driver of the boom, and of all the institutional innovations that came with it. The shadow banking system was a response to that driver, not a cause of it. The crisis did not mute that demand; quite the contrary the crisis increased it. And now regulatory response to the crisis is institutionalizing that heightened dollar demand in the form of regulatory liquidity ratios.
I conclude that a revival, in some form, of the dollar cross-border funding system is an inevitable part of our future financial system. Devising mechanisms of regulatory control and support of that system should be top priority.