By Frances Coppola
For international trading companies at that time, USD funding for trade finance became increasingly expensive. As banks pulled funds from countries perceived as risky, foreign currency exchange rates around the world became increasingly volatile, making FX funding and hedging for international trade extremely difficult. As result, global trade contracted considerably, causing losses for many international businesses.
Ten years on from the September 2008 start of the crisis, the question now is: Why did the dollar's exchange rate rise so much even though the U.S. was the epicenter of the crisis, and – importantly – could this happen again in a future crisis? Economists at the Bank for International Settlements (BIS) have identified four reasons for the dollar's unexpected exchange rate rise:
Many economists believed that a financial crisis centered on the U.S. would cause the dollar's exchange rate to fall.6 This was because of the global trade imbalances that had built up since the beginning of the 21st century.
The U.S current account deficit versus the rest of the world steadily widened from 2000 onwards, reaching 6.17 percent of GDP in the third quarter of 2006.7 Economic theory says that when foreign currency exchange rates are floating freely, current account deficits should be short-lived because exchange rates should adjust to rebalance trade. The currency exchange rates of countries with current account surpluses rise, making their exports less competitive and attracting imports, while those of countries with current account deficits fall, making their exports more competitive and discouraging imports. However, because the dollar was the world's premier reserve currency and the currency most used for international trade, international demand for dollars tended to keep the dollar's exchange rate too high for the U.S.'s current account deficit to ever close. Many economists therefore thought that a severe shock to the U.S. financial system would destroy confidence in the dollar, driving international businesses and investors towards other currencies such as the euro and the Chinese yuan. This would bring about a large dollar exchange rate depreciation which would close the U.S.'s current account deficit.
Prior to the 2008 financial crisis, poor performance in U.S. economic indicators such as GDP did tend to cause the dollar to fall. But after the failure of Lehman Brothers in September 2008, the opposite happened. Although the U.S. was the epicenter of the crisis and experienced rapid deterioration in key indicators, the dollar's exchange rate soared against all currencies except the Japanese yen. The U.S.'s current account deficit did diminish significantly, but this was despite the dollar's strength, as the Great Recession caused U.S. imports to fall more than exports.8
All of the world's major currencies are "safe havens" for their countries' own populations, but some are also regarded as safe havens by international investors. Globally, the three principal safe-haven currencies in 2008 were the Japanese yen, the Swiss franc and the U.S. dollar.
As the financial crisis gathered pace, investors around the world rushed to sell dollar-denominated U.S. subprime residential mortgage-backed securities (RMBS), collateralized debt obligations (CDOs) and credit default swaps (CDS), along with risky assets denominated in foreign currencies, such as developing country government bonds, corporate bonds and equities. Instead, investors bought U.S. Treasuries, and stored dollars in U.S. bank accounts which temporarily benefited from unlimited federal guarantees. The fire sale of assets and rush for dollar safety created a sudden demand for USD, which helped cause the dollar's foreign currency exchange rates to soar, particularly versus the currencies of countries with low dollar reserves, significant dollar-denominated debt and large current account deficits.9
Investors also moved funds into Japanese and Swiss government bonds, thus increasing demand for Japanese yen and Swiss francs. These exchange rates also rose versus other currencies, particularly those of developing countries.
Even as the dollar soared to the moon, the Japanese yen rose slightly higher largely due to the reversal of the yen-dollar carry trade. In the years before the crisis, U.S. interest rates were far higher than in Japan, so both Japanese and American investors had borrowed yen at low interest rates and exchanged it for USD, which they invested in higher-yielding U.S. dollar-denominated assets – including the ill-fated RMBS. When the financial crisis struck, they reversed this trade, selling USD-denominated assets for dollars and then exchanging the dollars for yen with which to pay off their yen loans or buy Japanese government bonds. The sudden spike in demand for yen pushed up its exchange rate versus the dollar.
There also is a fuller description of the yen-dollar carry trade and its role in the global financial crisis here.
Prior to the financial crisis, the global financial system had become very unbalanced. European banks held large quantities of USD-denominated assets such as RMBS and CDOs, but comparatively few USD deposits. Conversely, U.S. banks held few foreign-denominated assets but large quantities of USD deposits. To eliminate these mismatches, European banks borrowed USD from U.S. banks in the global interbank market. Interbank markets dried up from August 2007 onwards, due to fears about bank creditworthiness, so European banks took to obtaining USD by pledging assets (repo) and swapping other currencies (FX swaps). After the failure of Lehman Brothers in September 2008, repo funding dried up, leaving FX swaps as the only game in town. Unfortunately, however, U.S. banks had little need for European currencies. Thus, there was a glut of European currencies and an acute shortage of dollars, which caused the cost of funding in the global FX swap market to soar, helping to push up the USD exchange rate.10
International businesses, too, contributed to the global dollar shortage. As both the dollar's exchange rate and the cost of borrowing USD in international markets rose, companies found it ever more expensive to refinance dollar debt. So they exchanged their holdings of other currencies for dollars in order to pay down their dollar debts. This increased demand for USD and helped push up the dollar exchange rate.11
How ‘Overhedging' Affected USD's Exchange Rate
In the run-up to the financial crisis, many non-U.S. banks had invested in USD-denominated securities such as RMBS and CDOs. As the prices of these assets fell, the asset side of these banks' balance sheets shrank in value. As a result, they found themselves with more USD liabilities than USD assets – a condition known as "overhedged." To close this mismatch between the asset and liability sides of their USD balance sheets, the banks bought dollars and repaid (or did not refinance) USD-denominated debt. Non-U.S. banks paying off USD-denominated debt and buying USD increased global demand for USD while reducing its supply on international markets, thus driving the U.S. dollar exchange rate up.12
In many countries, bank regulation introduced since the financial crisis now discourages banks from relying on international markets to fund balance sheet mismatches. Regulators examine bank asset quality and conduct stress tests to see how well banks would survive a future crisis. Banks have been forced to build up capital buffers and liquidity reserves. So the dollar funding squeeze and overhedging that contributed to the U.S. dollar's appreciation in 2008 may not recur in a future crisis.
However, the U.S. dollar remains the world's reserve currency of choice, and is even more dominant in international trade than it was before the crisis. Nearly two-thirds of the world's total FX reserves are in dollars.13 Further, according to the BIS, in 2016 88 percent of all FX transactions involved USD.14 There is also a risk that as the Fed raises interest rates and shrinks its balance sheet, interest rates with Japan and the Eurozone could diverge sufficiently to encourage the development of large carry trades similar to the yen-dollar trade prior to the financial crisis.
Much has been done to prevent a financial crisis as severe as that in 2008 from ever happening again. It might be expected, therefore, that in future the dollar's exchange rate would respond negatively to financial turbulence centered on the U.S. However, the dollar remains dominant in global trade and finance. In a future financial crisis, therefore, safe haven effects, carry trade reversal and trade finance difficulties may yet cause the USD exchange rate to rise again.
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. “Trade weighted US dollar index, broad,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
2. “U.S Treasury yields,” FRED Economic Data; https://fred.stlouisfed.org/series/DGS10/
3. “The Federal Reserve’s response to the financial crisis and actions to foster maximum employment and price stability,” U.S. Federal Reserve; https://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm
5. “Dollar appreciation in 2008: safe haven, carry trades, dollar shortage and overhedging,” McCauley & McGuire, Bank for International Settlements; https://www.bis.org/publ/qtrpdf/r_qt0912i.pdf
6. “What explains global exchange rate movements during the financial crisis?,” European Central Bank; https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1060.pdf?e5ad3363438fcc1e4b644cee53725cb6
7. “Total Current Account Balance for the United States (DISCONTINUED),” FRED Economic Data; https://fred.stlouisfed.org/series/BPBLTT01USQ188S
8. “What explains global exchange rate movements during the financial crisis?,” European Central Bank; https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1060.pdf?e5ad3363438fcc1e4b644cee53725cb6
9. “What explains global exchange rate movements during the financial crisis?,” European Central Bank; https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1060.pdf?e5ad3363438fcc1e4b644cee53725cb6
10. “Dollar appreciation in 2008: safe haven, carry trades, dollar shortage and overhedging,” McCauley & McGuire, Bank for International Settlements; https://www.bis.org/publ/qtrpdf/r_qt0912i.pdf
13. “Currency Composition of Official Foreign Exchange Reserves,” International Monetary Fund; http://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4
14. “Triennial Central Bank Survey – Foreign Exchange Turnover in 2016,” Bank for International Settlements; https://www.bis.org/publ/rpfx16fx.pdf