Refusing free money is a sign of fear

By Andy Mukherjee
Fear is when you want to pick up the shiny nickel lying on the road, but freeze at the sound of the approaching steamroller. The currency market equivalent of this is a widening basis swap-free money that banks are too scared to pocket. For the fourth time in the past decade, the fear gauge is starting to go wild. 

Don’t ignore the warning, particularly in South Korea, a reliable indicator of trouble in the past. What’s happening in an esoteric corner of currency markets will also shape banking trends.

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When two parties swap currencies for, say, five years, every three or six months each earns interest in the currency it bought, and pays interest in the currency it sold. The dollar is usually involved: Someone, somewhere always wants the greenback to oil the wheels of commerce. It shouldn’t cost too much more to obtain dollars this way than to borrow them in the London interbank market. If it did, global banks would jump right in to arbitrage away the difference and make risk-free money in the process. 

Storm Brewing?

That used to be true before the 2008 crisis. Since the advent of the Dodd-Frank legislation and the Volcker rule, however, Wall Street banks’ risk appetite has dwindled, and a gaping basis swap spread — a numerical measure of badly wanting dollar funding and not getting it — has become a reliable indicator of nervousness around the world. One such squeeze is currently on. 

Read: Rupee hits all-time low; breaches 76-mark against US dollar

You see it in South Korea, where the roundabout way of raising dollar funding that I just described cost as much as 3% for three months Thursday, a hefty 2-percentage-point premium over the three-month Libor. That’s a lot of nickels begging to be picked up by global banks. But the crumbling of their own share prices amid the economic dislocation caused by the coronavirus is making lenders hesitant to expand their balance sheets. Might as well save capital for a share buyback.

The G-10 average of basis swap spreads, a favourite gauge of fear for researchers at the Bank for International Settlements, suggests the tightness in the dollar market has risen with the trade-weighted US currency. But the aggregate picture, while deteriorating, isn’t as bad yet as during the financial crisis. The G-10 basis swap spread is less than half as wide as it was in 2009, the eurozone troubles of 2011 or the 2016 dislocation after China’s sudden devaluation of the yuan. 

Crunch Time, Folks

The Korean won-dollar spread, however, is off the charts. It’s worrying, because South Korea has acted as a canary in the coal mine before. In 2007, Korean basis swaps started acting up in June — 15 months before the collapse of Lehman Brothers. Exporters wanted dollars, and they weren’t getting them. The situation was brought under control only after the Federal Reserve authorized temporary dollar-liquidity-swap arrangements with 14 central banks, including the Bank of Korea, between December of that year and October 2008. 

The Fed resuscitated the emergency lines late Thursday in Asia. Help couldn’t have arrived a moment sooner. A country’s hard-currency reserves — and Korea has $409 billion now, compared with $250 billion in June 2007 — are seldom enough to make the widespread panic go away. Regional reserve sharing arrangements, such as the Chiang Mai Initiative mutual-support network established by some Asian central banks, don’t work when trouble comes at the same time for everyone. 

The Canary Effect

Liquidity woes are showing up in other markets, too. Exchange-traded funds that track bond indexes have suddenly stopped following them, and Wall Street banks are reluctant to make money by closing the gap. 

What more can be done? One lesson from previous episodes, like the squeeze that erupted during the 2013 taper tantrum, is to avoid defending exchange rates. The rupiah has weakened 11% this year, the most of any Asian currency. But because it has adjusted swiftly, it’s relatively easier for Indonesian banks to get dollar funding. 

The other important lesson is this: King dollar is the currency of global multinationals, many of whom are now Asian. The banks that supply them, in good times and bad, will be wanted by every national banking regulator in their counties. But who are these white knights?