Why The Dollar Poses A Global Headache 3: Foreign Reserves
Needless to say, foreign governments are acutely aware of the problems posed by having to use the USD, and work to preempt them by stashing their Dollars as “foreign reserves”.
How and why does this happen?
(Note that this generally only applies to countries where the central bank runs some kind of currency intervention policy)
China provides us with a good example, as the People’s Bank of China (PBoC) sets a midpoint rate for USDCNY, and allows their currency to trade in a 2% band around it.
Consider the scenario where the USDCNY exchange rate trades below the 2% band, that is more people are exchanging USDs for CNY. In order to get the rate back within the band, the PBoC has to purchase Dollars.
The converse is true in the opposite scenario where USDCNY trades above the band, and the PBoC has to sell USDs to the market.
Over time, as the PBoC keeps intervening to ensure the exchange rate stays within its 2% band, it ends up with some amount of Dollars.
In order to earn some kind of income on this balance, foreign central banks often use the Dollars they have accumulated from their interventions to purchase US Treasuries. These Dollars and USTs held by foreign central banks are the famous “foreign reserves” that everyone likes to talk about when discussing international Dollar funding.
“Foreign” because they are a foreign currency, in this case USDs, and “reserves” because they are literally kept in reserve for the next Dollar funding crisis. (Do note that any form of non-domestic currency balance held by foreign central banks can be considered as foreign reserves, not just USDs.)
When the crisis strikes, central banks sell their USTs in the open market to get USDs, which they then use to provide their domestic financial systems with USD liquidity.
Why is this necessary?
Because during a Dollar crisis, banks become extremely reluctant to lend out the Dollars they have, for two main reasons.
Firstly, banks need the Dollars themselves, to ensure that they can meet their own USD liabilities; and to meet potential margin/collateral calls in the repo market that may arise if markets continue to sell off.
Secondly, extreme levels of market volatility makes counterparty risk very difficult to quantify. A seemingly healthy financial counterparty can on Monday appear perfectly safe to conduct business with, but be insolvent come Friday.
Needless to say, such levels of uncertainty cause banks (and everyone else, really) to severely curtail risk taking activity, such as USD based lending.
The result of which is the global banking system becomes unwilling to provide USD based financing almost overnight, except to maybe the most creditworthy clients. This means that in any given country outside the United States, local businesses that transact in international markets are no longer able to access the Dollars they need from both domestic and foreign banks.
This directly affects their ability to purchase raw materials, settle their bills, and if they sell their products or services overseas, collect on USD based receivables.
To be continued…
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