A Decade After the Crisis, King Dollar Is the World's Tyrant

By Jon Sindreu and Mike Bird Features Dow Jones Newswires

It is one of the ironies of the global financial crisis: A decade later, a panic whose origins were in the U.S. has left the dollar more important to the rest of the world than ever before.

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Putative contenders for its throne -- the euro, the Chinese yuan -- have failed to gain global acceptance. It remains the dominant force in world trade. A slow, yearslong decline in the proportion of dollars among the holdings of the world's central banks, which were trying to diversify, has stopped. And the commercial banks of Japan, Germany, France and the U.K. now have more dollar-denominated liabilities than those in their own currencies.

The dollar dominance is testing the world again: Rules designed to make finance safer have already made dollars harder to come by. To add to the pain, the Federal Reserve is now sucking dollars out of the world's financial system as it tries to tighten its monetary policy.

"'Our currency, your problem' -- it's basically like that," said Credit Suisse analyst and money-market guru Zoltan Pozsar, of the move by the U.S.

Since the financial crisis, markets have been flashing a red light, warning that dollars are scarce. Spreads on derivatives contracts called cross-currency basis swaps, which are used by investors and companies to source dollars, have jumped. Were greenbacks freely borrowed and lent, the spread would be zero, economists say.

Whenever banks need to clean up their books around quarter and year ends -- closing their dollar taps to borrowers -- the gulf gets bigger. As the end of 2017 approaches, the three-month spread has ballooned to a one-year high.

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The scramble for dollars can hurt non-U.S. banks as the currency's scarcity makes them more expensive to borrow. In December 2016, it drove French lender Société Générale SA to its worst trading day of the year -- and the only one when the bank's statistical estimates of probable losses were breached -- its annual report showed.

Swiss bank UBS Group AG breached its statistical model for group revenue at the same time. The lender said it was because of sharp movements in Swiss franc and euro interest rates, and declined to comment further.

Now Société Générale is working to put its own countermeasures in place, by diversifying sources of dollar funding across markets and types of investors.

"This is something that we're very careful and aware of," said Stéphane Landon, head of group treasury at Société Générale. "It's true that we have limited access to retail dollar funding. So we have developed more access to wholesale products overall," he added.

Mr. Pozsar of Credit Suisse calculates that each $100 billion that the U.S. central bank removes will lead to a widening of 0.1 percentage point in cross-currency basis swap spreads.

Since October, the Fed has been allowing $10 billion of its $4.5 trillion balance sheet -- acquired under bond-buying programs after the financial crisis -- to roll off every month, while the U.S. Treasury is stashing increasing amounts of cash at the central bank, and a U.S. tax reform is expected by analysts to drive American companies to repatriate a chunk of their cash stashed abroad.

All of this means that dollars are flowing out of the rest of the world's pockets. Researchers at the Switzerland-based Bank for International Settlements have found that, whenever the dollar becomes scarcer, credit gets harder to come by around the world.

Many economists have long predicted an end to the dollar reign that was established after World War II, especially after President Richard Nixon unpegged the greenback from gold in 1971. The creation of the euro in 1999 and the breakneck growth of the Chinese economy led many analysts to say the dollar would need to share the limelight.

But the euro became politically unpopular during the European debt crisis, and Chinese capital controls to peg the yuan are anathema to global investors. Meanwhile, the share o

f official reserves held in dollars recently stopped its multiyear decline, and in the second quarter of 2017, foreign-country dollar-denominated debt rose to an all-time high of $8.6 trillion, according to the BIS.

"The dollar's downward trend of the last 40 years is over," said Paresh Upadhyaya, fund manager at Amundi Pioneer, Europe's largest asset manager.

A one-currency dominance challenges economic models that see global financial markets as a flat surface where, on average, investors shouldn't be better or worse off depending on which currency they trade.

Reality tends to show something else.

In a famous depiction of the world economy, University of California Professor Benjamin J. Cohen arranged currencies in a pyramid, stacked on top of each other. In the 5th century B.C., the Greek drachma prevailed. Since World War II, the dollar has been "the only top currency."

Traders seem to have Mr. Cohen's pyramid in mind. Billions are made every year by borrowing the lower-yielding currencies of rich countries and investing in those of less-developed nations -- a popular strategy called "carry trade."

In derivatives markets, people who are able to sell dollars now and buy them in the future make money on average, while those who urgently need dollars lose an average of 0.9% each quarter, according to Commerzbank researcher Jessica James.

So will there be enough dollars for the world in the future?

Since the 1950s, that responsibility has fallen to the eurodollar market, an offshore London-based market roughly $5 trillion in size, dwarfing any other offshore lending market. Eurodollars are created by non-U.S. banks when they lend in dollars to their clients.

But unlike U.S. banks, these banks don't have access to the Fed in times of scarcity. It got so acute during the 2008 crisis that the Fed had to step in to save world markets by providing dollars directly to foreign central banks. These credit lines are still in place but are only used in extreme cases.

Foreign banks whose clients want a lot of dollars can make good money if they are able to provide them. So, bankers say, they are targeting depositors in oil-producing nations like Russia and Saudi Arabia, who receive their income in dollars, as well as central banks looking to stash their reserves.

In the past five years, Japan's top three banks have more than doubled their overseas and non-yen-denominated deposits to more than $600 billion.

And banks that can issue long-term dollar debt find it attractive to do so. "You've issued more in dollars than you would have done otherwise as that dislocation in the dollar basis swap developed," said Christoffer Møllenbach, head of treasury at Danske Bank. Since 2015, around 80% of the outstanding debt issued by the Danish lender has been dollar-denominated, according to Tradeweb data.

Yet, banks in the eurodollar market might not be capable of satiating the world's hunger for dollars, investors say, because postcrisis regulations have raised the cost of short-term lending. Ten years later, the Fed might test whether the global financial system can stand up by itself again.

"Above all the rest of the system, there's the eurodollar system," said Jeffrey Snider, head of global investment at Alhambra Investment Partners, "and if it doesn't work, the rest of the currencies don't work."

Write to Jon Sindreu at jon.sindreu@wsj.com and Mike Bird at Mike.Bird@wsj.com

(END) Dow Jones Newswires

November 26, 2017 07:14 ET (12:14 GMT)