Dollar Liquidity Tight

High cost of swapping local currency into US dollar is well reflected in basis swaps. Since the crisis started, it becomes difficult to raise dollars directly in cash markets and institutions with dollar needs have to turn to alternative dollar funding markets like the cross-currency basis swap market.

In this instance, institutions are forced to move from borrowing directly in the uncollateralized dollar cash market to the local currency’s uncollateralized cash market and then convert the proceeds into a dollar obligation through a foreign currency basis swap. This essentially translates into marked dislocations as reflected in the spread between the actual interest rate received on the leg of the swap and actual libor.

This indicates that the credit crunch is not yet over and it makes it expensive for foreign dollar-based issuers to tap non-dollar bond markets. If the situation persists, it would nto be surprised to see further unwinding of foreign holdings of local currency bonds and in combination with wider sovereign credit spreads, it makes dollar bonds issued by Asian governments to become more attractive relative to their local currency counterparts.

Volatility between on-shore and off-shore markets is expected to rise dramatically and that will lead to co-dependence of volatility regimes. Ongoing financial market volatility,
falling interest rates and concerns over the safety of bank deposits following the collapse of Northern Rock and Bear Stearns has focused institutional investors’ attention on their cash investments. Foreign order cancellations could also aggravate the situation as it could mean a need for foreign currency to settle the hedges.

It also presents an arbitrage opportunity for investors. Moreover, as a result of the credit crunch, it is extremely difficult for borrowers to issue corporate bonds offshore. Hedge funds, meanwhile, have stepped in to do Asian/dollar forward trades with Asian companies that are looking to hedge.

And, from another perspective, we have learned from different policy reactions to the currency speculation during the crisis, the subsequent high level of FX volatility has set the pace for the capital market liberalization.