On 2 October 2008 in The Dollar Rally and Imbalances in the US Dollar Holdings of Overseas Banks we said that:
When a multinational company deposits US dollar receipts from an export business in their domestic banks those deposits are frequently held in dollars... If those dollar assets decline because of a financial event as we are seeing today, the depositors may choose to withdraw their dollar deposit from the bank as they mature. This places the bank in an awkward position since the corresponding assets have deteriorated in value, but the nominal value of the certificate of deposit liability remains the same with the requisite interest accrual. As a result, a demand for dollars can be generated in the foreign country that is artificial but very real in terms of day to day banking operations. This is the 'artificial dollar short'
In the chart below we have updated the data from the BIS report to June of 2008, and the DX dollar index to today. In our October blog entry we forecasted that:
The resulting sharp rally in the US dollar is therefore likely to be an anomaly which will correct, and perhaps quite sharply, once the effect of the short term imbalances dissipates.
Although it is too early to say with certainty, it does appear that the hypothesis may be valid, and that the correlation is significant. The recent dollar rally was as the result of an artificial short squeeze resulting in an anomalous demand for dollars primarily in Europe.
The actions by the Federal Reserve and the foreign central banks to open their swap lines to relieve the dollar liquidity short squeeze appears to have been successful. We will see in the next series of BIS data how effective that effort has been, and if it will need to be continued as the imbalances are worked out of the system. As the ECB announced on September 13:
In order to facilitate the functioning of financial markets and provide liquidity in dollars, the Federal Reserve and the European Central Bank (ECB) have agreed on a swap arrangement. Under the agreement, the ECB would be eligible to draw up to $50 billion, receiving dollar deposits at the Federal Reserve Bank of New York; in exchange, the Federal Reserve Bank of New York will receive euro deposits of an equivalent amount at the ECB. The ECB will make these dollar deposits available to national central banks of the Eurosystem, which will use them to help meet dollar liquidity needs of European banks, whose operations have been affected by the recent disturbances in the United States.
We assume that at some point the ECB and BIS will take steps to modernize the international currency system to remove its exposure to the fluctuations of a single currency and the need for ad hoc arrangements to facilitate the proper functioning of international trade. Although a crisis has apparently been averted for now, it serves to expose the artificiality of the existing currency regime which may exist but not be as noticeable or measurable under more common conditions.
