We all hang together

BY 2023 THE global offshore dollar shadow banking system had grown larger than America’s onshore domestic banking system. The euro’s credibility had slipped further after Italy’s partial default in 2018. The yuan’s ambitions beyond its borders came to a standstill during the final days of Xi Jinping’s rule in September 2019. In a last effort to placate conservative elements within the party, capital controls were temporarily reimposed, the head of the People’s Bank of China arrested for “deviations” and yuan deposits in Hong Kong were frozen. The redback’s use abroad never recovered.

That meant the dollar was more in demand than ever as the only reliable medium of payment for global trade. The dollar assets of China’s largest bank, ICBC, overtook JPMorganChase’s entire balance-sheet. Total offshore dollar credit reached $26 trillion, or about 100% of America’s GDP. Emerging countries, with their trade still denominated in dollars, continued to build ever larger dollar reserves. Congress’s failure to approve reform of the IMF and the subsequent withdrawal of China, India and Brazil meant there was no global lender of last resort.

In order to create a bigger supply of safe assets, Congress came close to approving the creation of the Invest America Fund, which sold Treasuries to foreigners and invested in shares overseas. But a bitter ideological row over how its surplus earnings would be distributed left the legislation stuck in the Senate. The imbalance between the supply of and demand for Treasuries led to a heavily distorted market.

The crisis, when it struck, came from an unexpected source. Indonesian and Malaysian firms had invested heavily in solar-energy projects, financed by Chinese and other Asian banks, using dollars and supposedly hedged and in some cases redistributed off the banks’ balance-sheets, mainly to Asia’s burgeoning pension funds. When shale-oil drilling began in earnest in the European Union, oil prices fell to $14, making the solar projects uneconomic. Depositors and bond funds fled from the Asian dollar market into Treasuries, still the world’s only safe haven. Analysts estimated the need for emergency liquidity at $5 trillion-6 trillion.

The Federal Reserve proved unable to help. The Fair Fed act of 2017 had prevented it from extending more than $300 billion of liquidity to other central banks. None of the big Asian commercial banks had branches in New York; most had shut them in protest after the New York Superintendent of Financial Services, in an election year, had attempted to fine Bank of China $12 billion and India’s largest state banks $9 billion, alleging corruption in the banks’ home countries. That meant they were not eligible to access the Fed’s liquidity window.

In desperation, the central banks of China, India, Indonesia, Singapore and Malaysia agreed to pool their dollar reserves, totalling $8 trillion, and make massive liquidity injections into the Asian dollar banking system. At first it appeared they had stemmed the panic, with interbank rates falling. But as they sold down their holdings of American bonds, the price of Treasuries tumbled, pushing long-term American bond yields up by three percentage points and prompting talk of a housing crash rivalling that of 2007. In a settlement brokered by the Treasury secretary, Jamie Dimon, America agreed to allow the Fed to offer liquidity to Asian central banks in return for accepting their Treasury bonds as collateral. As the crisis eased, America, China and other Asian countries started talks to create a global lender of last resort and to promote the use of the yuan and rupee abroad. A new era of international co-operation had begun.