On Alphaville, Matthew Klein points out that covered interest parity (dollar vs. yen) is alive and kicking again. It wasn’t during much of 2016. The Reserve Bank of Australia exploited the arbitrage opportunity.
In a BIS working paper, Dagfinn Rime, Andreas Schrimpf, and Olav Syrstad analyze the apparent breakdown of covered interest parity (CIP). They argue that
CIP holds remarkably well for most potential arbitrageurs when applying their marginal funding rates. With severe funding liquidity differences, however, it becomes impossible for dealers to quote prices such that CIP holds across the full rate spectrum. A narrow set of global top-tier banks enjoys risk-less arbitrage opportunities as dealers set quotes to avert order flow imbalances.
In a speech, Hyun Song Shin points out that CIP increasingly fails to hold: the Dollar interest rate implied by FX swaps vis-a-vis the Euro, Yen, Pound or Swiss Franc is “too high.” Moreover, the deviation is negatively correlated with the Dollar’s spot exchange rate: When the Dollar appreciates, the deviation from CIP widens.
Shin argues that bank behavior explains the deviation:
… the US dollar is used widely throughout the global banking system, even when neither the lender nor the borrower is a US resident. … The consequence of the dollar’s international role in transactions is that the global banking system runs on dollars.
… key feature of the risk-taking channel is that when the dollar depreciates, banks lend more in US dollars to borrowers outside the United States. Similarly, when the dollar appreciates, banks lend less, or even shrink outright the lending of dollars. In this sense, the value of the dollar is a barometer of risk-taking and global credit conditions.
… The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting a squeeze on accumulated dollar liabilities built up during the previous period of easy dollar credit. During the period of dollar weakness, global banks were able to supply hedging services to institutional investors at reasonable cost, as cross-border dollar credit was growing strongly and easily obtained. However, as the dollar strengthens, the banking sector finds it more challenging to roll over the dollar credit previously supplied.
One way to summarise the finding is that there is a “triangle” that links a stronger dollar, more subdued dollar cross-border flows, and a widening of the cross-currency basis against the dollar.
With the Euro’s rising role as an international funding currency CIP deviations also show up for the Euro.
… the risk-taking channel for the euro is starting to show the tell-tale negative relationship between a weaker currency value and expanding cross-border lending in that currency; it was not there before the crisis, but has emerged since the crisis.
The financial channel of exchange rates operates when currency appreciation elicits valuation changes on borrower balance sheets. …
When we do international finance, we often buy into the “triple coincidence” where the GDP area, decision-making unit and currency area are one and the same … Currency appreciation or depreciation then acts on the economy through changes in net exports. [But that’s misleading.]