Posted on February 23, 2015

The US dollar (USD) has appreciated by about 17% against a basket of major currencies over the last twelve months.

The main driver of this appreciation has been the US Federal Reserve’s (Fed) expected increase in US short-term interest rates later this year, while most other central banks around the world continue to ease their policy stance. Going forward, this divergence of global monetary policy stances could lead to further USD appreciation, which is likely to have negative implications for the large unhedged USD positions in many Emerging Markets (EMs) and lead to a tight USD liquidity squeeze around the world. This would, in turn, aggravate the EM growth slowdown (see our economic commentary dated 21 December 2014) and further weaken the global recovery.

The USD continues to be the main currency for financial and trade transactions around the world. When the USD appreciates against other currencies, more resources from non-USD denominated countries are needed to pay for the same amount of financial and trade services provided in USD.

This essential role of the USD became apparent during the Global Financial Crisis of 2008-09, when the whole world rushed for a safe haven in the US Treasury Bond market, but there was not enough USD liquidity available. The pricing of USD liquidity became prohibitive, making it difficult to settle many USD financial and trade transactions. In the end, the Fed had to intervene by opening up bilateral swap lines with other major central banks around the world in order to provide the necessary liquidity to meet the increased demand for USD.

A similar liquidity squeeze may be in the making now. According to the Bank for International Settlement, credit to non-bank borrowers outside the United States totalled USD9.2tn at end-September 2014. This represents an increase in USD exposure outside of the US of over 50% since end-2009, with the largest increase coming from Asia. Most of this credit growth outside of the US has been driven by the historically low interest rates associated with the Fed’s successive rounds of Quantitative Easing (QE). Corporates, in particular, have taken advantage of low US interest rates to fund their operations in USD. Anecdotal evidence suggests that about USD1.4tn of this outstanding credit is held by Chinese corporates, mostly unhedged for exchange rate movements. Smaller amounts are also held mostly unhedged by other Asian and Latin American EMs. In India, for example, the Reserve Bank of India disclosed in October 2014 that only 15% of all corporate debt (mostly in USD) was hedged as of August 2014, compared with 34% in March 2014.

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As QE came to an end in October 2014 and the US economy strengthened in the second half of 2014, the USD started to appreciate. As a result, many of the unhedged corporates that borrowed in USD during the QE period will now require a larger amount of domestic resources to pay their USD-denominated debt. This is likely to have a negative impact on their investment plans and operations, leading to a further slowdown of economic growth in EMs.

At the same time, the appreciation of the USD, the expected rise in US short-term interest rates and negative interest rates in Europe are pushing global asset managers to move a larger share of their portfolios into USD-denominated assets. This, in turn, is increasing the demand for USD outside of the US, whereas the supply of USD liquidity US remains limited given the end of US QE. There are therefore increasing signs from swap markets that USD liquidity is increasingly becoming more expensive and difficult to secure. Pricing of 12-month swap contracts for offshore Chinese Renminbi has reached an all-time high in recent weeks. To a lesser extent, five-year basis swap spreads (in essence the cost of hedging against USD movements over five years) have recently risen against the British pound, the euro and the Swiss franc, although they remain well below the highs during the euro crisis of 2011-12.

Looking forward, these trends are likely to continue if the USD continues to appreciate. First, it will become increasingly more expensive for corporates in Asia and other EMs to unravel their unhedged USD positions, leading to a further slowdown in economic growth in these countries. Second, the expected rise in US short-term interest rates will add to the already strong incentives to hold USD-denominated assets, which could lead to a squeeze in global USD liquidity. Both these phenomena are going to have a negative impact on an already fragile global recovery and may lead to significant further volatility in financial markets in the months ahead.