By Frances Coppola
Today, though, U.S. companies can enjoy just such an advantage, as CIP appears to have underperformed since the financial crisis.
CIP says that the difference between the interest rates in two currencies in the cash money markets of their respective countries should be the same as the difference between the spot and forward exchange rates in those currencies. If the foreign exchange risk can be fully hedged with forward contracts, the cost of borrowing should therefore be the same in both currencies. Conversely, if companies can reduce their cost of funds with cross-currency borrowing and FX swaps, it implies that foreign exchange risk cannot be fully hedged.
So, if FX markets are working efficiently, it should not be possible for a business to cut its cost of funds by – for example - borrowing in euros and swapping into dollars rather than borrowing dollars directly in the cash money markets. If any such possibility exists, it should be short-lived, as those who buy and sell currency simultaneously take advantage of the difference to make profits.1
And yet … the European Central Bank’s negative interest rate policy and quantitative easing (QE) have reduced interest rates on euro-denominated corporate bonds. For some time, U.S. corporations have been obtaining dollar funding by issuing so-called “reverse yankees” (euro-denominated bonds) and swapping the euros for dollars. Since this makes sense only if it reduces their cost of funds, it seems that FX markets are not working quite as efficiently as theory expects.2
In an interesting paper, the Bank for International Settlements (BIS) explains that since the start of the financial crisis in 2007, CIP appears to have broken down: “This is visible in the persistence of a cross-currency basis since 2007. The cross-currency basis indicates the amount by which the interest paid to borrow one currency by swapping it against another differs from the cost of directly borrowing this currency in the cash market. Thus, a non-zero cross-currency basis indicates a violation of CIP. Since 2007, the basis for lending US dollars against most currencies, notably the euro and yen, has been negative: borrowing dollars through the FX swap market became more expensive than direct funding in the dollar cash market. For some currencies, such as the Australian dollar, it has been positive.”3
But why has a persistent cross-currency basis in major currencies opened up since the financial crisis? And – importantly for companies considering their foreign exchange risk management strategies – is it likely to continue?
The principal reason for the cross-currency basis is the divergence of central bank monetary policy. “Much of the widening of the USD basis since 2014 has coincided with monetary policy easing announcements by the Bank of Japan (BoJ) and the ECB,” says BIS. As the Federal Reserve ended QE and started raising interest rates,4 the BoJ and the ECB introduced negative interest rates and quantitative easing (QE). U.S. companies can exploit this divergence.5
Interestingly, BIS says that “reverse yankee” bonds, and their associated currency swaps, are mostly long-term (10 years or more). Corporations are locking in for the long term the current very low interest rates on euro-denominated corporate bonds. This suggests that corporations don’t expect monetary policy to remain divergent indefinitely.
But monetary policy alone cannot explain the persistence of the cross-currency basis. For some reason, the spot and forward currency exchange rates of the euro and the yen versus the U.S. dollar have not adjusted sufficiently to eliminate it. This points to a second reason – the pricing of currency swaps.
Businesses use financial derivatives such as currency swaps to hedge against interest rate and foreign exchange risks. But on the other side of these hedge trades are speculators, often large banks. Speculators both buy and sell derivatives, and they incur considerable balance sheet risk in doing so.6
BIS says that prior to the financial crisis, these risks were not properly priced. So, when net demand for FX swaps was high, large banks simply absorbed the increased demand by leveraging up their balance sheets. The trouble was, some of them raised their balance sheet leverage to dangerous levels. Since the crisis, therefore, banks – forced to tighten credit risk standards and improve liquidity and capital buffers – have reduced their exposure to currency swaps.
Consequently, it now costs more to hedge foreign exchange risk using swaps: “As a result of tighter management of risks and related balance sheet constraints, arbitrage now incurs a cost per unit of balance sheet. This cost is passed on to the pricing of FX swaps, introducing a premium (or discount, depending on the currency) in response to imbalances in the swap market. One result is that the currency spot-forward relationship goes out of line with CIP.”7
BIS suggests that, while tight controls on credit risk, liquidity and capital requirements remain, arbitrageurs may be reluctant to accommodate persistently high demand for currency swaps arising from corporations exploiting cross-currency interest rate differentials. If BIS is right, then the cross-currency basis cannot fully close, and there will continue to be opportunities for international businesses to reduce funding costs by borrowing in foreign currencies.
Divergent central bank monetary policy encourages U.S. companies to look for opportunities to reduce their cost of funds by funding themselves in foreign currencies and swapping into dollars. Because of tighter controls on banks and market-makers, these opportunities are proving persistent. This could potentially generate cost advantages for companies pursuing active foreign exchange rate risk management strategies.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. "Covered interest parity", Investopedia; http://www.investopedia.com/terms/c/covered-interest-rate-parity.asp.
2. "Reverse Yankees dominate euro bond market", Financial Times; https://www.ft.com/content/e29ab99c-8ea7-11e5-a549-b89a1dfede9b
3. "Covered interest parity lost: understanding the cross-currency basis", Bank for International Settlements; http://www.bis.org/publ/qtrpdf/r_qt1609e.htm
4. FRB Press Release December 16, 2015; https://www.federalreserve.gov/newsevents/press/monetary/20151216a.htm
5. "Divergent monetary policies and the world economy", Vitor Constancio, ECB; https://www.ecb.europa.eu/press/key/date/2015/html/sp151015.en.html
6. "The basic mechanics of FX swaps and cross-currency basis swaps", Bank for International Settlements; http://www.bis.org/publ/qtrpdf/r_qt0803z.htm
7. "Covered interest parity lost: understanding the cross-currency basis", Bank for International Settlements; http://www.bis.org/publ/qtrpdf/r_qt1609e.htm