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What Can Explain the Tale of Two FX Swap Rates in the Offshore Dollar Funding Market?

Published by Anonymous (not verified) on Sat, 06/06/2020 - 12:12am in

This Piece is part of the Stable Funding Series, by Elham Saeidinezhad

Mary Stigum once said, “Don’t fight
the Fed!” There is perhaps no better advice that someone can give to an
investor than to heed these words.

After the COVID-19 crisis, most
aspects of the dollar funding market have shown some bizarre developments. In
particular, the LIBOR-OIS spread, which used to be the primary measure of the
cost of dollar funding globally, is losing its relevance. This spread has been
sidelined by the strong bond between the rivals, namely CP/CD ratio and the FX
swap basis. The problem is that such a switch, if proved to be premature, could
create uncertainty, rather than stability, in the financial market. The
COVID-19 crisis has already mystified the relationship between these two key
dollar funding rates – CP/CD and FX swap basis- in at least two ways. First,
even though they should logically track each other tightly according to the
arbitrage conditions, they diverged markedly during the pandemic episode.
Second, an unusual anomaly had emerged in the FX swap markets, when the market
signaled a US dollar premium and discount simultaneously.  For
the scholars of Money View, these so-called anomalies are a legitimate child of
the modern international monetary system where agents are disciplined, or
rewarded, based on their position in the hierarchy. This hierarchy is created
by the hand of God, aka the Fed, whose impact on nearly all financial assets
and the money market, in particular, is so unmistakable. In this monetary
system, a Darwinian inequality, which is determined by how close a country is
to the sole issuer of the US dollar, the Fed, is an inherent quality of the

Most of these developments
ultimately have their roots in dislocations in the banking
system. At the heart of the issue is that a decade after the GFC, the private
US Banks are still pulling back from supplying offshore dollar funding. Banks’
reluctance to lend has widened the LIBOR-OIS spread and made the Eurodollar
market less attractive. Money market funds are filling the void and becoming
the leading providers of dollar funding globally. Consequently, the CP/CD
ratio, which measures the cost of borrowing from money market funds,
has replaced a bank-centric, LIBOR-OIS spread and has become one of the primary
indicators of offshore dollar funding costs.

The market for offshore dollar
funding is also facing displacements on the demand side. International investors,
including non-US banks, appear to utilize the FX swap market as the primary
source of raising dollar funding. Traditionally, the bank-centric market for
Eurodollar deposits was the one-stop-shop for these investors. Such a switch
has made the FX swap basis, or “the basis,” another significant thermometer for
calculating the cost of global dollar funding. This piece shows that this shift
of reliance from banks to market-based finance to obtain dollar funding has
created odd trends in the dollar funding costs.

Further, in the world of
market-based finance, channeling dollars to non-banks is not straightforward as
unlike banks, non-banks are not allowed to transact directly with the central
bank. Even though the Fed started such a direct relationship through Money
Market Mutual Fund Liquidity Facility or MMLF, the pandemic revealed that there
are attendant difficulties, both in principle and in practice. Banks’ defiance
to be stable providers of the dollar funding has created such irregularities in
this market and difficulties for the central bankers.

The first peculiar trend in the
global dollar funding is that the FX swap basis has continuously remained
non-zero after the pandemic, defying the arbitrage condition. The FX swap basis
is the difference between the dollar interest rate in the money market and the
implied dollar interest rate from the FX swap market where someone borrows
dollars by pledging another currency collateral. Arbitrage suggests that any
differences between these two rates should be short-lived as there is always an
arbitrageur, usually a carry trader, inclined to borrow from the market that
offers a low rate and lend in the other market, where the rate is high. The
carry trader will earn a nearly risk-free rate in the process. A negative
(positive) basis means that borrowing dollars through FX swaps is more
expensive (cheaper) than borrowing in the dollar money market.

Even so, the most significant irregularity in the FX swap markets had emerged when the market signaled a US dollar premium and a discount simultaneously.  The key to deciphering this complexity is to carefully examine the two interest rates that anchor FX swap pricing. The first component of the FX swap basis reflects the cost of raising dollar funding directly from the banks. In the international monetary system, not all banks are created equal. For the US banks who have direct access to the Fed’s liquidity facilities and a few other high-powered non-US banks, whose national central banks have swap lines with the Fed, the borrowing cost is close to a risk-free interest rate (OIS). At the same time, other non-US banks who do not have any access to the central bank’s dollar liquidity facilities should borrow from the unsecured Eurodollar market, and pay a higher rate, called LIBOR.

As a result, for corporations that
do not have credit lines with the banks that are at the top of the hierarchy,
borrowing from the banking system might be more expensive than the FX swap
market. For these countries, the US dollar trades at a discount in the FX swap
market. Contrarily, when banks finance their dollar lending activities at a
risk-free rate, the OIS rate, borrowing from banks might be less more expensive
for the firms. In this case, the US dollar trades at a premium in the FX swap
market. To sum up, how connected, or disconnected, a country’s banking system
is to the sole issuer of the dollar, i.e., the Fed, partially determines
whether the US dollar funding is cheaper in the money market or the FX swap

The other crucial interest rate that
anchors FX swap pricing and is at the heart of this anomaly in the FX swap
market is the “implied US dollar interest rate in the FX swap market.” 
This implied rate, as the name suggests, reflects the cost of obtaining dollar
funding indirectly. In this case, the firms initially issue non-bank domestic
money market instruments, such as commercial papers (CP) or certificates of
deposits (CDs), to raise national currency and convert the proceeds to
the US dollar. Commercial paper (CP) is a form of short-term unsecured debt
commonly issued by banks and non-financial corporations and primarily held
by prime money market funds (MMFs). Similarly, certificates of deposit (CDs)
are unsecured debt instruments issued by banks and largely held by non-bank
investors, including prime MMFs. Both instruments are important sources
of funding for international firms, including non-US banks. The economic
justification of this approach highly depends on the active presence of Money
Market Funds
(MMFs), and their ability and willingness, to purchase
short-term money market instruments, such as CPs or CDs.

To elaborate on this point, let’s
use an example. Let us assume that a Japanese firm wants to raise $750 million.
The first strategy is to borrow dollars directly from a Japanese bank that has
access to the global dollar funding market. Another competing strategy is to
raise this money by issuing yen-denominated commercial paper, and then use
those yens as collateral, and swap them for fixed-rate dollars of the same
term. The latter approach is only economically viable if there are prime MMFs
that are able and willing, to purchase that CP, or CD, that are issued by that
firm, at a desirable rate. It also depends on FX swap dealers’ ability and
willingness to use its balance sheet to find a party wanting to do the flip
side of this swap. If for any reason these prime MMFs decide to withdraw from
the CP or CD market, which has been the case after the COVID-19 crisis, then
the cost of choosing this strategy to raise dollar funding is unequivocally
high for this Japanese firm. This implies that the disruptions in the CP/CD
markets, caused by the inability of the MMFs to be the major buyer in these
markets, echo globally via the FX swap market.

On the other hand, if prime MMFs
continue to supply liquidity by purchasing CPs, raising dollar funding
indirectly via the FX swap market becomes an economically attractive solution
for our Japanese firm. This is especially true when the regional banks cannot
finance their offshore dollar lending activities at the OIS rate and ask for
higher rates. In this case, rather than directly going to a bank, a borrower
might raise national currency by issuing CP and swap the national currency into
fixed-rate dollars in the FX swap market. Quite the contrary, if issuing
short-term money market instruments in the domestic financial market is
expensive, due to the withdrawal of MMFs from this market, for instance, the
investors in that particular region might find the banking system the only
viable option to obtain dollar funding even when the bank rates are high. For
such countries, the high cost of bank-lending, and the shortage of bank-centric
dollar funding, is an essential threat to the monetary stability of the firms,
and the domestic monetary system as a whole.

After the COVID-19 crisis, it is like a tug of war emerged between OIS rates and the LIBORs as to which type of interest rate that anchor FX swap pricing. Following the pandemic, the LIBOR-OIS spread widened significantly and this war was intensified. Money View declares the winner, even before the war ends, to be the bankers, and non-bankers, who have direct, or at least secure path to the Fed’s balance sheet. Marcy Stigum, in her seminal book, made it clear not to fight the Fed and emphasized the powerful role of the Federal Reserve in the monetary system! Time and time again, investors have learned that it is fruitless to ignore the Fed’s powerful influence. Yet, some authors put little effort into trying to gain a better understanding of this powerful institution. They see the Fed as too complex, secretive, and mysterious to be readily understood. This list of scholars does not include Money View scholars. In the Money View framework, the US banks that have access to the Fed’s balance sheet are at the highest layer of the private banking hierarchy. Following them are a few non-US banks that have indirect access to the Fed’s swap lines through their national central bank. For the rest of the world, having access to the world reserve currency only depends on the mercy of the Gods.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post What Can Explain the Tale of Two FX Swap Rates in the Offshore Dollar Funding Market? appeared first on Economic Questions.

If banks are Absent from the Wholesale Money Market, what exactly is their function?

Published by Anonymous (not verified) on Wed, 27/05/2020 - 4:21am in

In Search of More Stable Liquidity

By Elham Saeidinezhad | The COVID-19 crisis has revealed the resiliency of the banking system compared to the Great Financial Crisis (GFC). At the same time, it also put banks’ absence from typically bank-centric markets on display. Banks have already demonstrated their objection to passing credit to small-and-medium enterprises (SMEs). In doing so, they rejected their traditional role as financial intermediaries for the retail depositors. This phenomenon is not surprising for scholars of “Money View”. The rise of market-based finance coincides with the fading role of banks as financial intermediaries. Money View asserts that banks have switched their business model to become the lenders and dealers in the interbank lending and the repo market, both wholesale markets, respectively. Banks lend to each other via the interbank lending market, and use the proceeds to make market in funding liquidity via the repo market.

Aftermath the COVID-19 crisis, however, an episode in the market
for term funding
cast a dark shadow over such doctrine. The issue is
that it appears that interbank lending no longer
serves as the significant marginal source of term funding for banks. Money
Market Funds (MMFs) filled the void in other wholesale money markets, such as
markets for commercial paper and the repo market. After the pandemic, MMFs
curtailed their repo lending, both with dealers and in the cleared repo
segment, to accommodate outflows. This decision by MMFs increased the cost of
term dollar funding in the wholesale money market. This distortion was
contained only when the Fed directly assisted MMFs through Money Market Mutual
Fund Liquidity Facility or MMLF. Money View emphasizes the unique role of banks
in the liquidity hierarchy since their liabilities (bank deposits) are a means
of payment. Yet, such developments call into question the exact role of banks,
who have unique access to the Fed’s balance sheet, in the financial system.
Some scholars warned that instruments, such as the repo, suck
out liquidity when it most needed. A deeper look might reveal that it is not
money market instruments that are at fault for creating
liquidity issues but the inconsistency between the banks’ perceived, and actual
significance, as providers of liquidity during a crisis.

There are two kinds of MMFs: prime and government. The former issue shares
as their liabilities and hold corporate bonds as their assets while the latter
use the shares to finance their holding of safe government debts. By
construction, the shares have the same risk structure as the underlying pool of
government bonds or corporate bonds. In doing so, the MMFs act as a form of
financial intermediaries. However, this kind of intermediation is different
from a classic, textbook, one. MMFs mainly use diversification to pool
and not so much to transform it. Traditional financial
intermediaries, on the other hand, use their balance sheet to transform risk-
they turn liquid liabilities (overnight checkable deposits) into illiquid
assets (long term loans). There is some liquidity benefit for
the mutual fund shareholder from diversification. But such a business model
implies that MMFs have to keep cash or lines of credit, which reduces their

To improve the profit margin, MMFs have also become active providers of
liquidity in the market for term funding, using instruments such as commercial
paper (CP) and the repo. Commercial paper (CP) is an unsecured promissory note
with a fixed maturity, usually three months. The issuer,
mostly banks and non-financial institutions, promises to pay the buyer some
fixed amount on some future date but pledges no assets, only her liquidity and
established earning power, guaranteeing that promise. Investment companies,
principally money funds and mutual funds, are
the single biggest class of investors in commercial paper. Similarly, MMFs are
also active in the repo market. They usually lend cash to the repo market, both
through dealers and cleared repo segments. At its early stages, the CP market
was a local market that tended, by investment banking standards, to be
populated by less sophisticated, less intense, less motivated people. Also,
MMFs were just one of several essential players in the repo market. The
COVID-19 crisis, however, revealed a structural change in both markets, where
MMFs have become the primary providers of dollar funding to banks.

It all started when the pandemic forced the MMFs to readjust their portfolio to meet their cash outflow commitments. In the CP market, MMFs reduced their holding of CP in favor of holding risk-free assets such as government securities. In the repo market, they curtailed their repo lending both to dealers and in the cleared segment of the market. Originally, such developments were not considered a threat to financial stability. In this market, banks were regarded as the primary providers of dollar funding. The models of market-based finance, such as the one provided by Money View framework, tend to highlight banks’ function as dealers in the wholesale money market, and the main providers of funding liquidity. In these models, banks set the price of funding liquidity and earn an inside spread. Banks borrow from the interbank lending market and pay an overnight rate. They then lend the proceeds in the term-funding market (mostly through repo), and earn term rate. Further, more traditional models of bank-based financial systems depict banks as financial intermediaries between depositors and borrowers. Regardless of which model to trust, since the pandemic did not create significant disturbances in the banking system, it was expected that the banks would pick up the slack quickly after MMFs retracted from the market.

The problem is that the coronavirus casts doubt on both models, and
highlights the shadowy role of banks in providing funding liquidity. The
experience with the PPP loans to SMEs shows that banks are no longer
traditional financial intermediaries in the retail money market. At the same
time, the developments in the wholesale money market demonstrate that it is
MMFs, and no longer banks, who are the primary providers of
term funding and determine the price of dollar funding. A possible explanation
could be that on the one hand, banks have difficulty raising overnight funding
via the interbank lending market. On the other hand, their balance sheet
constraints discourage them from performing their function as money market
dealers and supply term funding to the rest of the financial system. The bottom
line is that the pandemic has revealed that MMFs, rather than large banks, had
become vital providers of US dollar funding for other banks and non-bank
financial institutions. Such discoveries emphasize the instability of funding
liquidity in bank-centric wholesale and retail money markets.

The withdrawals of MMFs from providing term funding to banks in the CP markets, and their decision to decease their reverse repo positions (lending cash against Treasuries as collateral) with dealers (mostly large banks), translated into a persistent increase of US dollar funding costs globally. Even though it was not surprising in the beginning to see a tension in the wholesale money market due to the withdrawal of the MMFs, the Fed was stunned by the extent of the turbulences. This is what caused the Fed to start filling the void that was created by MMFs’ withdrawal directly by creating new facilities such as MMLF. According to the BIS data, by mid-March, the cost of borrowing US funding widened to levels second only to those during the GFC even though, unlike the GFC, the banking system was not the primary source of distress. A key reason is that MMFs have come to play an essential role in determining US dollar funding both in a secured repo market and an unsecured CP market. In other words, interbank lending no longer serves as a significant source of funding for banks. Instead, non-bank institutional investors such as MMFs constitute the most critical wholesale funding providers for banks. The strength of MMFs, not the large, cash-rich, banks, has, therefore, become an essential measure of bank funding conditions. 

The wide swings in dollar funding costs, caused by MMFs’ withdrawal from these markets, hampered the transmission of the Fed’s rate cuts and other facilities aimed at providing stimulus to the economy in the face of the shock. With banks’ capacity as dealers were impaired, and MMFs role was diminished, the Fed took over this function of dealer of last resort in the wholesale money market. Interestingly, the Fed acted as a dealer of last resort via its MMLF facility rather than assuming the role of banks in this market. The goal was to put an explicit floor on the CP’s price and then directly purchase three-month CP from issuers via Commercial Paper Funding Facility (CPFF). These operations also have broader implications for the future of central bank financial policies that might include MMFs rather than banks. The Fed’s choice of policies aftermath the pandemic was the unofficial acknowledgment that it is MMFs’ role, rather than banks’, that has become a crucial barometer for measuring the health of the market for dollar funding. Such revelation demands us to ask a delicate question of what precisely the banks’ function has become in the modern financial system. In other words, is it justifiable to keep providing the exclusive privilege of having access to the central bank’s balance sheet to the banks?

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post If banks are Absent from the Wholesale Money Market, what exactly is their function? appeared first on Economic Questions.

Is the Government’s Ambiguity about the Secondary Market a Terminal Design Flaw at the Heart of the PPP Loans?

Published by Anonymous (not verified) on Thu, 14/05/2020 - 2:26am in

The COVID-19 crisis has created
numerous risks for small and medium enterprises (SMEs). The only certainty for
SMEs has been that the government’s support has been too flawed to mitigate the
shock. The program’s crash is not an accident. As mentioned in the previous Money View blog, one of the PPP loan design flaws is the government’s
reliance on banks to act traditionally and intermediate credit to SMEs. Another
essential, yet not well-understood design flaw at the heart of
the PPP loan program is its ambiguity about the secondary market.
The structure I propose to resolve such uncertainty focuses on the explicit
government guarantee for the securitization of the PPP loans, similar to the
GSE’s role in the mortgage finance system.

Such flaws are the byproduct of the
central bank’s tendency to isolate shadow banking, and its related activities,
from traditional banking. These kinds of bias would not exist in the “Money
View” framework, where shadow banking is a function rather
than an entity. “Money market funding of capital
market lending
” is a business deal that can happen in the balance sheet
of any entity- including banks and central banks. One way to identify a
shadow banker from a traditional banker is to focus on their sources and
uses of finance. A traditional banker is simply a credit
intermediary. Her alchemy is to facilitate economic growth by bridging any
potential mismatch between the kind of liabilities that borrowers want to issue
(use of finance) and the nature of assets that creditors want to hold (source
of funding). Nowadays, the mismatch between the preferences of borrowers and
the preferences of lenders is increasingly resolved by “price changes” in the
capital market, where securities are traded, rather than by traditional
intermediation. Further, banks are reluctant to act as a financial intermediary
for retail depositors as they have already switched to their more lucrative
role as money market dealers.

Modern finance emphasizes that no
risk is eliminated in the process of “credit intermediation,” only
transferred, and sometimes quite opaquely. Such a conviction gave birth to the
rise of market-based finance. In this world, a shadow banker, sometimes a bank,
uses its source of funding, usually overnight loans, to supply “term-funding”
in the wholesale money market. In doing so, it acts as a dealer in the
wholesale money market. Also, financial engineering techniques, such as
securitization, by splitting the securitized assets into different tranches,
allows a shadow banker to “enhance credit ” while transferring risks to
those who can shoulder them. The magic of securitization enables a shadow
banker to tap capital-market credit in the secondary market. Ignoring the
secondary market is a fatal problem in the design of PPP loans.

To understand the government
pandemic stimulus program for the SMEs, let’s start by understanding the PPP
loan structure. The U.S. Treasury, along with financial regulators such as the
Fed, adopted two measures to facilitate aid to SMEs under the CARES Act. First,
the Fed announced the formation of the Paycheck Protection Program Loan
Facility (the “PPPLF”). This program enables insured depository institutions to
obtain financing
from the Fed collateralized by Paycheck Protection Program
(“PPP”) loans. The point to emphasize here is that the Fed, in essence, is the
ultimate financier of such loans as banks could use the credits to SMEs as
collateral to finance their lending from the Fed. Second, PPP loans are
assigned a zero-percent risk-weight for purposes of U.S. risk-based capital
requirements. This feature is essentially making PPP loans exempt from
risk-based (but not leverage) capital requirements when held by a banking
organization subject to U.S. capital requirements. 

Despite the promising appearance of
such programs, the money is not flowing towards SMEs. One of the deadly flaws
of this program is that it overlooks the importance of the secondary market.
Specifically, ambiguity exists regarding the Small Business Administration
(SBA)’s role in the secondary market due to the nature of the PPP loans
and how they are regulated. The CARES Act provides that PPP loans are a traditional
of the SBA guaranteed loan. Such a statement implies that the PPP
loans would not be 100% guaranteed in the secondary market as the SBA
guaranteed loans are subject to certain conditions that should
be satisfied by the borrower. First, the SBA wants to ensure that the entity
claiming a right to payment from the SBA holds a valid title to the SBA loan.
Second, the SBA requires the borrower to fulfill the PPP’s forgiveness
requirements. Securitization requires the consent of the SBA. What is not
mentioned in the CARES Act is that the SBA’s existing regulations restrict the
ability of such loans to be transferred in the secondary market. Such
restrictions block the credit to flow to the SMEs.

Under such circumstances, free
transfer of PPPs in the secondary market could result in chaos when the PPP
loans are later presented to the SBA by the holder for forgiveness or
guarantee. Some might propose to ask for approval from the SBA before the
securitization process. Yet, prior approval requirements for loan transfers,
even though it might reduce the confusion mentioned above, hinder the ability
to transfer newly originated PPP loans into the secondary market. Given that
the PPP entails a massive amount of loans – $349 billion – to be originated in
a short period, transfer restrictions could have a material impact on the
ability to get much-needed funding to small businesses quickly. The program’s
failure to notice such a conflict is a byproduct of the government’s tendency
to ignore the role of the secondary market in the success of programs that aims
at providing credit to retail depositors.

A potential solution would be for a
government agency, such as the Small Business Administration (SBA), to
guarantee the PPP loans in the secondary market in the same manner as Fannie
Mae and Freddie Mac do for the mortgage loans. Fannie Mae and Freddie Mac are
government-sponsored enterprises (the GSEs) that purchase mortgages from banks
and use securitization to enhance the flow of credit in the mortgage market.
The GSEs help the flow of credit as they have a de facto subsidy from
the government. The market believes that the government will step in to guarantee
their debt if they become insolvent. For the case of the PPP loans, instead of
banks keeping the loans on their balance sheet until the loan was repaid, the
bank who made the loan to the SMEs (the originator) should be able to sell the
loan to the SBA. The SBA then would package the PPP loans and sells the payment
rights to investors. The point to emphasize here is that the government both
finance such loans in the primary market- the Fed accepts the PPP loans as
collateral from banks- and ensures the flow of credit by securitizing them in
the secondary market. Such a mechanism provides an unambiguous and ultimate
guarantee for the PPP loans in the credit market that the government aims at
offering anyways. This kind of explicit government guarantee could also help
the smooth flow of credit to SMEs, which has been the original goal of the
government in the first place.

Money View, through its recognition
of banks as money market dealers in market-based finance and originators of
securitized assets, could shed some light on the origins of those
complications. Previously in the Money View blog, I proposed a potential solution to circumvent banks and
directly injecting credit to the SMEs, through tools such as central bank
digital currencies (CBDC). In this piece, the proposal is to adopt the design
of the mortgage finance system to provide unambiguous government support and
resolve the perplexities regarding marketing PPP loans in the secondary market.
Until this confusion is resolved, banking entities with regulatory or internal
funding constraints may be unwilling to originate PPP loans without a clear
path for obtaining financing or otherwise transferring such credits into the
secondary market. Such failures come at the expense of retail depositors,
including small businesses.

Acknowledgment: Writing this piece would not be possible without a fruitful
exchange that I had with
Dr. Rafael Lima Sakr, a Teaching Fellow at Edinburgh Law School.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post Is the Government’s Ambiguity about the Secondary Market a Terminal Design Flaw at the Heart of the PPP Loans? appeared first on Economic Questions.

Not such a Great Equalizer after all

Published by Anonymous (not verified) on Sat, 09/05/2020 - 11:00pm in

Because it has no regard for borders, the coronavirus has been referred to as the Great Equalizer. But its impact is not equal by any stretch of the imagination. While China, Europe, and Northern America may recover relatively fast, emerging market economies are less resilient. The combined health, economic, and financial tolls they now endure may cause them to face the greatest recession in decades.

By Jack Gao | When COVID-19 hit, China’s strong state and centralized public administration allowed it to suppress the domestic spread. In Europe, welfare systems and appropriate policy responses made sure workers have less to worry about when economies reopen. The United States (despite Trump’s handling leaving much to be desired) enjoys a unique status of its own. The American economy and “exorbitant privilege” of the US dollar mean that policy responses can be put forth in short order, and with relatively few negative repercussions. For most emerging market economies, however, none of this can be taken for granted. The coronavirus is shaping up to be the “perfect storm” that many feared. It could sink the developing world into a deep economic recession.

No Doctors and No Food

Let’s start with public health. While the increase of new deaths in the epicenters—US, UK, Italy, Spain—appears to be slowing, the virus rages on in major developing nations. Russia, India, Mexico, and Brazil continue to report well above a thousand new daily deaths, and many of them are still on an upward trajectory. In India, a brief relaxation of the lockdown was met with a jump in deaths, underscoring that the fight to contain the virus will be an uphill battle.

Although health systems are being tested everywhere, the ones in developing countries were already under strain before COVID-19 reared its head. For example, the average number of health workers per 1000 people in OCED countries is 12.3. In the African region, this ratio is only 1.4.

As if the health crisis is not crushing enough, the United Nations warns of a “hunger pandemic” as an additional 130 million people could be pushed to the brink of starvation this year, with the vast majority of them in developing countries. The coronavirus may cross borders easily, but the suffering it causes is not equal across countries.

Locked Down and Out of Work

If the human toll of the pandemic is appalling, the economic damages to countries are unprecedented as well, as countries implement lockdown and “social distancing” to combat the virus. In the latest World Economic Outlook growth projections by the IMF, emerging market economies as a whole are expected to contract 1% this year, for the first time since the Great Depression. Literally all developing countries may be in economic decline as a result of COVID-19, with India and China eking out paltry growth. Still, these headline numbers mask the true extent of economic hardship.

Take working from home, for example. Economists have documented a clear relationship between the share of jobs that can be done at home and the national income level. In a developed country like the United States, some 37 percent of jobs can be performed at home—education, finance and IT being at the top of the scale. In some developing economies, less than 10 percent of jobs can be done remotely.

On top of all this, global remittances are collapsing. The amount of money transferred to migrants’ home countries may fall by 20 percent as workers see dwindling employment. This is terrible news for countries like Lesotho, where remittances are as much as 16% of GDP.

Where’d the money go?

The global financial system exacerbates these struggles with its core and periphery topology. During good times, foreign capital flows into emerging markets, looking for higher yields. But in bad times, when that capital is needed most, it swiftly disappears. This dynamic is now on full display. As investors started to realize the true scale of the pandemic and major central banks initiated new rounds of monetary easing, emerging economies saw capital flight as investors rushed to safer assets. An estimated 100 billion portfolio dollars fled emerging markets in the first quarter alone.

In the face of such severe dollar shortages and liquidity crunch in developing countries, the Federal Reserve had to expand central bank liquidity swaps and launch a new lending facility to come to the rescue. The impact of such international measures is still an open question. But with currency depreciation, higher borrowing costs, declining official reserves, and falling commodity prices, it appears that the financial stress emerging economies are under may be difficult to reverse.

The Triple Whammy

This way, developing countries face a health-blow, and economic-blow, and a financial-blow, all at once. An emerging market economy faced with just one of those would have resulted in a crisis. But amid COVID-19, all emerging economies were are confronted with all three crises at the same time. The damage done by this “triple whammy” could plague the developing world for years to come.

Jack Gao is a Program Economist at the Institute for New Economic Thinking. He is interested in international economics and finance, energy policy, economic development, and the Chinese economy.  He previously worked in financial product and data departments in Bloomberg Singapore, and reported on Asian financial markets in Bloomberg News from Shanghai. Jack holds a MPA in International Development from Harvard Kennedy School, and a B.S. in Economics from Singapore Management University. He has published articles on China Policy Review and Harvard Kennedy School Review.

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Forget about the “Corona Bond.” Should the ECB Purchase Eurozone Government Bond ETFs?

Published by Anonymous (not verified) on Fri, 01/05/2020 - 8:50am in

By Elham Saeidinezhad | In recent history, one of a few constants about the European Union (EU) is that it follows the U.S. footstep after any disaster. After the COVID-19 crisis, the Fed expanded the scope and duration of the Municipal Liquidity Facility (MLF) to ease the fiscal conditions of the states and the cities. The facility enables lending to states and municipalities to help manage cash flow stresses caused by the coronavirus pandemic. In a similar move, the ECB expanded its support for the virus-hit EU economies in response to the coronavirus pandemic. Initiatives such as Pandemic Emergency Purchase Programme (PEPP) allow the ECB to open the door to buy Greek sovereign bonds for the first time since the country’s sovereign debt crisis by announcing a waiver for its debt. 

There the similarity ends. While the market sentiment about the Fed’s
support program for municipals is very positive, a few caveats in the ECB’s
program have made the Union vulnerable to a market run. Fitch has just cut
Italy’s credit rating to just above junk. The problem is that unlike the U.S.,
the European Union is only a monetary union,
and it does not have a fiscal union. The investors’ prevailing
view is that the ECB is not doing enough to support governments of southern
Europe, such as Spain, Italy, and Greece, who are hardest hit by the virus.
Anxieties about the Union’s fiscal stability are behind repeated calls for the
European Union to issue common eurozone bonds or “corona bond.” Yet, the
political case, especially from Northern European countries, is firmly against
such plans. Further, despite the extreme financial needs of the Southern
countries, the ECB is reluctant to lift its self-imposed limits not to buy more
than a third of the eligible sovereign bonds of any single country and to purchase
sovereign bonds in proportion to the weight of each country’s investment in its
capital. This unwillingness is also a political choice rather than an economic

It is in that context that this piece proposes the ECB to include the
Eurozone government bond ETF to its asset purchasing program. Purchasing
government debts via the medium of the ETFs can provide the key to the thorny
dilemma that is shaking the foundation of the European Union. It can also be
the right step towards creating a borrowing system that would allow poorer EU
nations to take out cheap loans with the more affluent members guaranteeing the
funds would be returned. The unity of EU members faces a new, painful test with
the coronavirus crisis. This is why the Italian Prime Minister Guiseppe Conte
warned that if the bloc fails to stand up to it, the entire project might “lose
its foundations.” The ECB’s decision to purchase Eurozone sovereign debt ETFs
would provide an equal opportunity for all the EU countries to meet the COVID-19
excessive financial requirements at an acceptable price. Further, compared to
the corona bond, it is less politically incorrect and more common amongst the
central bankers, including those at the Fed and the Bank of Japan.

In the index fund ecosystem, the ETFs are more liquid and easier to trade
than the basket of underlying bonds. What lies behind this “liquidity
” is the different equilibrium structure and the
efficiency properties in markets for these two asset classes. In other words, the
dealers make markets for these assets under various market conditions. In the
market for sovereign bonds, the debt that is issued by governments, especially
countries with lower credit ratings, do not trade very much. So, the dealers
expect to establish long positions in these bonds. Such positions expose them
to the counterparty risk and the high cost of holding inventories. Higher price
risk and funding costs are correlated with an increase in spreads for dealers.
Higher bid-ask spreads, in turn, makes trading of sovereign debt securities,
especially those issued by countries such as Italy, Spain, Portugal, and
Greece, more expensive and less attractive.

On the contrary, the ETFs, including the Eurozone government bond ETFs, are
considerably more tradable than the underlying bonds for at least two reasons.
First, the ETF functions as the “price discovery” vehicle
because this is where investors choose to transact. The economists call the ETF
a price discovery vehicle since it reveals the prices that best match the
buyers with the sellers. At these prices, the buying and selling quantities are
just in balance, and the dealers’ profitability is maximized. According to
Treynor Model, these “market prices” are the closest thing to the “fundamental
value” as they balance the supply and demand. Such an equilibrium structure has
implications for the dealers. The make markers in the ETFs are more likely to
have a “matched book,” which means that their liabilities are the same as their
assets and are hedged against the price risk. The instruments that are traded
under such efficiency properties, including the ETFs, enjoy a high level of
market liquidity.

Second, traders, such as asset managers, who want to sell the ETF, would not
need to be worried about the underlying illiquid bonds. Long
before investors require to acquire these bonds, the sponsor of the ETF, known
as “authorized participants” will be buying the
securities that the ETF wants to hold. Traditionally, authorized participants
are large banks. They earn bid-ask spreads by providing market liquidity for
these underlying securities in the secondary market or service fees collected
from clients yearning to execute primary trades. Providing this service is not
risk-free. Mehrling
makes clear that the problem is that supporting markets in this way
requires the ability to expand banks’ balance sheets on both sides, buying the
unwanted assets and funding that purchase with borrowed money. The strength of
banks to do that on their account is now severely limited. Despite such balance
sheet constraints, by acting as “dealers of near last resort,” banks provide an
additional line of defense in the risk management system of the asset managers.
Banks make it less likely for the investors to end up purchasing the illiquid
underlying assets.

That the alchemists have created another accident in waiting has been a fear
of bond market mavens and regulators for several years. Yet, in the era of
COVID-19, the alchemy of the ETF liquidity could dampen the crisis in making by
boosting virus-hit countries’ financial capacity. Rising debt across
Europe due to the COVID-19 crisis could imperil the sustainability of public
finances. This makes Treasury bonds issued by countries such as Greece, Spain,
Portugal, and Italy less tradable. Such uncertainty would increase the funding
costs of external bond issuance by sovereigns. The ECB’s attempt to purchase
Eurozone government bonds ETFs could partially resolve such funding problems
during the crisis. Further, such operations are less risky than buying the
underlying assets.

Some might argue the ETFs create an illusion of liquidity and expose the affluent members of the ECB to an unacceptably high level of defaults by the weakest members. Yet, at least two “real” elements, namely the price discovery process and the existence of authorized participants who act as the dealers of the near last resort, allows the ETFs to conduct liquidity transformation and become less risky than the underlying bonds. Passive investing sometimes is called as “worse than Marxism.” The argument is that at least communists tried to allocate resources efficiently, while index funds just blindly invest according to an arbitrary benchmark’s formula. Yet, devouring capitalism might be the most efficient way for the ECB to circumvent political obstacles and save European capitalism from itself.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

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