What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia?

Abstract

Asian countries have high demand for US dollars and are sensitive to US dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow US dollars or other currencies on a hedged basis via the cross-currency swap markets. These deviations can be explained by regulatory changes since the GFC, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of US dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while eases financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market, or stable long-term investors, including a “hedging counterpart of last resort,” can help stabilize financial intermediation when US dollar funding markets come under stress.

Appendix

Annex. A Simple Model of FX Hedging Demand

In this annex, we present a simple model of a non-U.S. bank’s demand for FX swaps to understand the implications of a higher basis and FX hedging costs on domestic financial conditions. The model is based on Ivashina et al. (2015) and Iida et al. (2016), which describes global bank’s demand for FX swaps.

We consider the following two scenarios that could affect bank’s demand for FX swaps: (1) an exogenous widening of the cross-currency basis; and (2) an increase in the interest rate differential. We assume that an increase in local currency (LCU)-denominated assets would lead to an easing of domestic financial conditions, while the opposite would lead to a tightening of domestic financial conditions.

A non-U.S. bank invests in two types of assets: USD-denominated assets (loans and bonds, etc.) that are issued by borrowers in the United States (L^US), and local currency (LCU)-denominated assets (L^D) that are issued by borrowers in the domestic market. The expected gross return of loans will be g_L(∙) and g_US(∙), respectively, which are concave functions of the amount of loans.

The bank faces an overall capital constraint on lending, where the aggregate lending cannot exceed capital: L^US + L^D ≤ K. The constraint is more likely to bind with a tighter regulatory capital regime or higher external equity financing cost, in which case the bank would prefer to hold on to its capital instead of lending. As in Ivashina et al. (2015), the bank has a default probability of p and the size of the default is denoted by α.

On the liability side, the bank has three possible sources of funding: LCU-denominated funding (such as deposits) (D^L), USD-denominated funding (D^US), and FX swaps (S). Following Iida et al. (2016), the cost of domestic funding is determined by c_L(D^L), comprising of two parts: the interest payment that the bank pays on its deposits and the convex cost of expanding the retail deposits. The interest rate paid to its depositors is the domestic risk-free rate, r, assuming that deposits are fully guaranteed by the government. The latter part assumes that the more the bank expands its retail deposits, the higher the cost it incurs. The cost of US dollar funding is determined by c_US(D^US), defined in a similar way as c_L(D^L), except that the default probability of the bank is taken into consideration (Fig. 10).

Fig. 10

Balance Sheet of a Non-U.S. Bank with Positive Demand for FX swaps

If the bank’s loans in USD exceed the liabilities in USD, the bank raises USD-funding from the FX swap market, as the bank does not take FX risks. The mismatch between assets and liabilities (US dollar funding gap) determines the bank’s hedging demand, i.e. demand for FX swap. The funding cost for FX swaps is determined as (r^US − r − ∆), where ∆ is the cross-currency basis. When CIP holds, ∆ is zero. Finally, we assume that the minimum size of liquidity needs is exogenous given and denoted by V.

As a result, the bank’s profit is determined by the following functions:

$$ {g}_L=\left({L}^L\right)\left(1+q\right){L}^L-\frac{\tau^L}{2}{\left({L}^L\right)}^{2.} $$

$$ {g}_{US}\left({L}^{US}\right)=\left(1+{q}^{US}\right){L}^{US}-\frac{\tau^{US}}{2}{\left({L}^{US}\right)}^2 $$

$$ {c}_L\left({D}^L\right)=\left(1+r\right){D}^L+\frac{\eta^L}{2}\mathit{\max}{\left({D}^L\right)}^2 $$

$$ {c}_{US}\left({D}^{US}\right)+\left(1+{r}^{US}+ p\alpha \right){D}^{US}+\frac{\eta^{US}}{2}{\left({D}^{US}\right)}^2 $$

Here, τ^L and τ^US are costs associated with the loans denominated in local-currency and US dollar, respectively. η^L and η^US are the costs associated with changing the size of a bank’s balance sheets.

The objective of the bank is to maximize its profits, π, which is the sum of the following: (1) return on L^L, (2) return on L^US, (3) cost of D^L, (4) cost of D^US and (5) cost of FX swaps. The bank’s maximization problem is as follows:

$$ \underset{L^L,{L}^{US},{D}^L,{D}^{US},S}{\max}\left\{{g}_L\left({L}^L\right)+{g}_{US}\left({L}^{US}\right)-{c}_L\left({D}^L\right)-{c}_{US}\left({D}^{US}\right)-\left({r}^{US}-r-\Delta \right)S\right\} $$

subject to

$$ \mathrm{M}\ge \mathrm{V} $$

$$ {L}^L={D}^L-S $$

$$ {L}^{US}+M={D}^{US}+S $$

Taking the first-order condition of the bank’s optimization problem and assuming that costs related to both increasing loans and balance sheets are the same for different currencies, i.e. τ^L = τ^US and η^L = η^US, the optimal amount of USD-denominated assets held by a non-US banks are given as follows:

$$ {L}^{US}=\frac{1}{\tau +\eta}\left\{\left(1+\frac{\eta }{2\tau}\right)\left({q}^{US}-{r}^{US}\right)-\frac{\eta }{2\tau}\left(q-r\right)-\frac{\tau +\eta }{2\tau}\Delta -\frac{p}{2}\alpha -\frac{\eta }{2}V\right\} $$

(1)

Similarly, the optimal amount of local-currency denominated assets held by a non-US banks are derived as follows:

$$ {L}^L=\frac{1}{\tau +\eta}\left\{\left(1-\frac{\eta }{2\tau}\right)\left(q-r\right)-\frac{\eta }{2\tau}\left({q}^{US}-{r}^{US}\right)+\frac{\tau +\eta }{2\tau}\Delta -\frac{p}{2}\alpha -\frac{\eta }{2}V\right\} $$

(2)

We consider the following two scenarios that could affect the bank’s demand for FX swaps: (i) an exogenous widening of cross-currency basis; and (ii) an exogenous increase in interest rate differential. From eqs. (1) and (2), we find that

• An increase in cross-currency basis (Δ) will lead banks to increase their assets in local currency, and a decrease in US dollar-denominated assets. This is consistent with the findings in Ivashina et al. (2015).

• An increase in the U.S. policy rates (q^US or q^US − r^US). If the Federal Reserve increases policy rate, driving the interest rate differentials to widen, ceteris paribus, this will lead banks to invest more in US dollar-denominated assets and less in local-currency denominated assets.

Net liabilities position vis-à-vis the US dollar. So far, we have implicitly assumed that the cost of domestic financing is relatively low, to ensure that the dollar gap exists and the demand for FX swaps takes a positive value. Let’s now consider a bank with net liabilities position vis-à-vis the U.S. dollar. This is relevant for banks in countries with net negative IIP position, such as emerging economies, where the cost of raising funding domestically may be high or limited. In the model, suppose the cost of raising funding (η^L) is very high. Ceteris paribus, this implies an inevitably high reliance on US dollar funding (D^US), as the equilibrium level of domestic funding (D^L) is low. For this case, an increase in cross-currency basis (Δ) reduces the funding from FX swaps (S), but domestic financing cannot be raised to compensate for this reduction in funding. With higher costs of the U.S. dollar funding, overseas borrowing cannot be expanded either. The reduction in total liabilities leads the bank to reduce its overall assets, which will tighten domestic financial conditions.

Finally, an interesting case to consider, which we do not explore in the empirical section, is the case when both factors increase at the same time. For instance, the U.S. rate and the cross-currency basis may rise at the same time, as implicitly suggested by Avdjiev et al. 2017. Suppose the U.S. monetary policy eventually resumes its normalization path. It often involves strengthening of the US dollar against other currencies. According to Avdjiev et al. 2017, a strong U.S. dollar is correlated with a negative cross-currency basis. In such case, the bank’s decision for more offshore investment is not straightforward – despite a higher U.S rate, higher FX hedging costs will lower hedge-adjusted returns in USD-denominated assets. The net effects of these two forces would depend on the parameter values.