Liquidity squeeze averted, but brace for more stress in US dollar funding

THE ongoing health, economic and financial crisis sparked by the spread of Covid-19 is justifiably considered worse than the global financial crisis of 2008. As the pandemic cuts a wider swathe among populations and several countries impose travel restrictions and domestic lockdowns, central banks have begun to roll out monetary and fiscal measures to cushion the economic and financial hardships that are yet to fully play out. Few industries will be spared, except perhaps those that enable work-from-home arrangements. But there is one corner of financial markets that could well be a harbinger of yet more stress - the US dollar funding market. Over the past week before the US Federal Reserve and other central banks stepped in to raise liquidity, credit markets began to seize up as investors rushed to hoard the dollar, invoking the spectre of a squeeze not unlike the 2008 crisis, and yet also different in scale.

The stresses in US dollar funding sparked by Covid-19 are not totally unexpected, given the heavy indebtedness among governments and corporates which have coasted on easy money and low interest rates. Over the years, the centrality of the dollar for trade, business and international transactions has only grown. As recently as October 2019, the International Monetary Fund raised concerns over the vulnerabilities that might arise from a "dollar disruption'' - that is, a squeeze as seen just last week. Based on the IMF's Global Financial Stability Report last year, non-US banks' role in US in dollar lending is growing. As at 2018, their US dollar assets rose to US$12.4 trillion from US$9.7 trillion in 2012. The gap between dollar denominated assets and liabilities widened to about US$1.4 trillion compared to US$1 trillion in 2008. This gap is filled by instruments such as foreign currency swaps which can be costly in times of stress.

Last week, six central banks including the US Federal Reserve stepped in to ease the strain through coordinated action via their standing US dollar liquidity swap line arrangements. The Fed last week also added temporary swap arrangements with nine other central banks, including the Monetary Authority of Singapore and the Reserve Bank of Australia. MAS said it aims to draw on the US$60 billion swap facility to provide US dollar liquidity to financial institutions in Singapore. The Fed, in turn, explained that by supporting dollar funding markets overseas, "we hope to maintain the flow of credit to US households and firms, reduce dislocations to US financial markets emanating from financial turbulence abroad, and by supporting foreign growth, maintain export markets for US producers''.