COVID-19 Archives

What Can Explain the Tale of Two FX Swap Rates in the Offshore Dollar Funding Market?

This Piece is part of the Stable Funding Series, by Elham Saeidinezhad

Mary Stigum once said, “Don’t fight the Fed!” There is perhaps no better advice that someone can give to an investor than to heed these words.

After the COVID-19 crisis, most aspects of the dollar funding market have shown some bizarre developments. In particular, the LIBOR-OIS spread, which used to be the primary measure of the cost of dollar funding globally, is losing its relevance. This spread has been sidelined by the strong bond between the rivals, namely CP/CD ratio and the FX swap basis. The problem is that such a switch, if proved to be premature, could create uncertainty, rather than stability, in the financial market. The COVID-19 crisis has already mystified the relationship between these two key dollar funding rates – CP/CD and FX swap basis- in at least two ways. First, even though they should logically track each other tightly according to the arbitrage conditions, they diverged markedly during the pandemic episode. Second, an unusual anomaly had emerged in the FX swap markets, when the market signaled a US dollar premium and discount simultaneously. For the scholars of Money View, these so-called anomalies are a legitimate child of the modern international monetary system where agents are disciplined, or rewarded, based on their position in the hierarchy. This hierarchy is created by the hand of God, aka the Fed, whose impact on nearly all financial assets and the money market, in particular, is so unmistakable. In this monetary system, a Darwinian inequality, which is determined by how close a country is to the sole issuer of the US dollar, the Fed, is an inherent quality of the system.

Most of these developments ultimately have their roots in dislocations in the banking system. At the heart of the issue is that a decade after the GFC, the private US Banks are still pulling back from supplying offshore dollar funding. Banks’ reluctance to lend has widened the LIBOR-OIS spread and made the Eurodollar market less attractive. Money market funds are filling the void and becoming the leading providers of dollar funding globally. Consequently, the CP/CD ratio, which measures the cost of borrowing from money market funds, has replaced a bank-centric, LIBOR-OIS spread and has become one of the primary indicators of offshore dollar funding costs.

The market for offshore dollar funding is also facing displacements on the demand side. International investors, including non-US banks, appear to utilize the FX swap market as the primary source of raising dollar funding. Traditionally, the bank-centric market for Eurodollar deposits was the one-stop-shop for these investors. Such a switch has made the FX swap basis, or “the basis,” another significant thermometer for calculating the cost of global dollar funding. This piece shows that this shift of reliance from banks to market-based finance to obtain dollar funding has created odd trends in the dollar funding costs.

Further, in the world of market-based finance, channeling dollars to non-banks is not straightforward as unlike banks, non-banks are not allowed to transact directly with the central bank. Even though the Fed started such a direct relationship through Money Market Mutual Fund Liquidity Facility or MMLF, the pandemic revealed that there are attendant difficulties, both in principle and in practice. Banks’ defiance to be stable providers of the dollar funding has created such irregularities in this market and difficulties for the central bankers.

The first peculiar trend in the global dollar funding is that the FX swap basis has continuously remained non-zero after the pandemic, defying the arbitrage condition. The FX swap basis is the difference between the dollar interest rate in the money market and the implied dollar interest rate from the FX swap market where someone borrows dollars by pledging another currency collateral. Arbitrage suggests that any differences between these two rates should be short-lived as there is always an arbitrageur, usually a carry trader, inclined to borrow from the market that offers a low rate and lend in the other market, where the rate is high. The carry trader will earn a nearly risk-free rate in the process. A negative (positive) basis means that borrowing dollars through FX swaps is more expensive (cheaper) than borrowing in the dollar money market.

Even so, the most significant irregularity in the FX swap markets had emerged when the market signaled a US dollar premium and a discount simultaneously. The key to deciphering this complexity is to carefully examine the two interest rates that anchor FX swap pricing. The first component of the FX swap basis reflects the cost of raising dollar funding directly from the banks. In the international monetary system, not all banks are created equal. For the US banks who have direct access to the Fed’s liquidity facilities and a few other high-powered non-US banks, whose national central banks have swap lines with the Fed, the borrowing cost is close to a risk-free interest rate (OIS). At the same time, other non-US banks who do not have any access to the central bank’s dollar liquidity facilities should borrow from the unsecured Eurodollar market, and pay a higher rate, called LIBOR.

As a result, for corporations that do not have credit lines with the banks that are at the top of the hierarchy, borrowing from the banking system might be more expensive than the FX swap market. For these countries, the US dollar trades at a discount in the FX swap market. Contrarily, when banks finance their dollar lending activities at a risk-free rate, the OIS rate, borrowing from banks might be less more expensive for the firms. In this case, the US dollar trades at a premium in the FX swap market. To sum up, how connected, or disconnected, a country’s banking system is to the sole issuer of the dollar, i.e., the Fed, partially determines whether the US dollar funding is cheaper in the money market or the FX swap market.

The other crucial interest rate that anchors FX swap pricing and is at the heart of this anomaly in the FX swap market is the “implied US dollar interest rate in the FX swap market.” This implied rate, as the name suggests, reflects the cost of obtaining dollar funding indirectly. In this case, the firms initially issue non-bank domestic money market instruments, such as commercial papers (CP) or certificates of deposits (CDs), to raise national currency and convert the proceeds to the US dollar. Commercial paper (CP) is a form of short-term unsecured debt commonly issued by banks and non-financial corporations and primarily held by prime money market funds (MMFs). Similarly, certificates of deposit (CDs) are unsecured debt instruments issued by banks and largely held by non-bank investors, including prime MMFs. Both instruments are important sources of funding for international firms, including non-US banks. The economic justification of this approach highly depends on the active presence of Money Market Funds (MMFs), and their ability and willingness, to purchase short-term money market instruments, such as CPs or CDs.

To elaborate on this point, let’s use an example. Let us assume that a Japanese firm wants to raise $750 million. The first strategy is to borrow dollars directly from a Japanese bank that has access to the global dollar funding market. Another competing strategy is to raise this money by issuing yen-denominated commercial paper, and then use those yens as collateral, and swap them for fixed-rate dollars of the same term. The latter approach is only economically viable if there are prime MMFs that are able and willing, to purchase that CP, or CD, that are issued by that firm, at a desirable rate. It also depends on FX swap dealers’ ability and willingness to use its balance sheet to find a party wanting to do the flip side of this swap. If for any reason these prime MMFs decide to withdraw from the CP or CD market, which has been the case after the COVID-19 crisis, then the cost of choosing this strategy to raise dollar funding is unequivocally high for this Japanese firm. This implies that the disruptions in the CP/CD markets, caused by the inability of the MMFs to be the major buyer in these markets, echo globally via the FX swap market.

On the other hand, if prime MMFs continue to supply liquidity by purchasing CPs, raising dollar funding indirectly via the FX swap market becomes an economically attractive solution for our Japanese firm. This is especially true when the regional banks cannot finance their offshore dollar lending activities at the OIS rate and ask for higher rates. In this case, rather than directly going to a bank, a borrower might raise national currency by issuing CP and swap the national currency into fixed-rate dollars in the FX swap market. Quite the contrary, if issuing short-term money market instruments in the domestic financial market is expensive, due to the withdrawal of MMFs from this market, for instance, the investors in that particular region might find the banking system the only viable option to obtain dollar funding even when the bank rates are high. For such countries, the high cost of bank-lending, and the shortage of bank-centric dollar funding, is an essential threat to the monetary stability of the firms, and the domestic monetary system as a whole.

After the COVID-19 crisis, it is like a tug of war emerged between OIS rates and the LIBORs as to which type of interest rate that anchor FX swap pricing. Following the pandemic, the LIBOR-OIS spread widened significantly and this war was intensified. Money View declares the winner, even before the war ends, to be the bankers, and non-bankers, who have direct, or at least secure path to the Fed’s balance sheet. Marcy Stigum, in her seminal book, made it clear not to fight the Fed and emphasized the powerful role of the Federal Reserve in the monetary system! Time and time again, investors have learned that it is fruitless to ignore the Fed’s powerful influence. Yet, some authors put little effort into trying to gain a better understanding of this powerful institution. They see the Fed as too complex, secretive, and mysterious to be readily understood. This list of scholars does not include Money View scholars. In the Money View framework, the US banks that have access to the Fed’s balance sheet are at the highest layer of the private banking hierarchy. Following them are a few non-US banks that have indirect access to the Fed’s swap lines through their national central bank. For the rest of the world, having access to the world reserve currency only depends on the mercy of the Gods.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

If banks are Absent from the Wholesale Money Market, what exactly is their function?

In Search of More Stable Liquidity Providers

By Elham Saeidinezhad | The COVID-19 crisis has revealed the resiliency of the banking system compared to the Great Financial Crisis (GFC). At the same time, it also put banks’ absence from typically bank-centric markets on display. Banks have already demonstrated their objection to passing credit to small-and-medium enterprises (SMEs). In doing so, they rejected their traditional role as financial intermediaries for the retail depositors. This phenomenon is not surprising for scholars of “Money View”. The rise of market-based finance coincides with the fading role of banks as financial intermediaries. Money View asserts that banks have switched their business model to become the lenders and dealers in the interbank lending and the repo market, both wholesale markets, respectively. Banks lend to each other via the interbank lending market, and use the proceeds to make market in funding liquidity via the repo market.

Aftermath the COVID-19 crisis, however, an episode in the market for term funding cast a dark shadow over such doctrine. The issue is that it appears that interbank lending no longer serves as the significant marginal source of term funding for banks. Money Market Funds (MMFs) filled the void in other wholesale money markets, such as markets for commercial paper and the repo market. After the pandemic, MMFs curtailed their repo lending, both with dealers and in the cleared repo segment, to accommodate outflows. This decision by MMFs increased the cost of term dollar funding in the wholesale money market. This distortion was contained only when the Fed directly assisted MMFs through Money Market Mutual Fund Liquidity Facility or MMLF. Money View emphasizes the unique role of banks in the liquidity hierarchy since their liabilities (bank deposits) are a means of payment. Yet, such developments call into question the exact role of banks, who have unique access to the Fed’s balance sheet, in the financial system. Some scholars warned that instruments, such as the repo, suck out liquidity when it most needed. A deeper look might reveal that it is not money market instruments that are at fault for creating liquidity issues but the inconsistency between the banks’ perceived, and actual significance, as providers of liquidity during a crisis.

There are two kinds of MMFs: prime and government. The former issue shares as their liabilities and hold corporate bonds as their assets while the latter use the shares to finance their holding of safe government debts. By construction, the shares have the same risk structure as the underlying pool of government bonds or corporate bonds. In doing so, the MMFs act as a form of financial intermediaries. However, this kind of intermediation is different from a classic, textbook, one. MMFs mainly use diversification to pool risk and not so much to transform it. Traditional financial intermediaries, on the other hand, use their balance sheet to transform risk- they turn liquid liabilities (overnight checkable deposits) into illiquid assets (long term loans). There is some liquidity benefit for the mutual fund shareholder from diversification. But such a business model implies that MMFs have to keep cash or lines of credit, which reduces their return.

To improve the profit margin, MMFs have also become active providers of liquidity in the market for term funding, using instruments such as commercial paper (CP) and the repo. Commercial paper (CP) is an unsecured promissory note with a fixed maturity, usually three months. The issuer, mostly banks and non-financial institutions, promises to pay the buyer some fixed amount on some future date but pledges no assets, only her liquidity and established earning power, guaranteeing that promise. Investment companies, principally money funds and mutual funds, are the single biggest class of investors in commercial paper. Similarly, MMFs are also active in the repo market. They usually lend cash to the repo market, both through dealers and cleared repo segments. At its early stages, the CP market was a local market that tended, by investment banking standards, to be populated by less sophisticated, less intense, less motivated people. Also, MMFs were just one of several essential players in the repo market. The COVID-19 crisis, however, revealed a structural change in both markets, where MMFs have become the primary providers of dollar funding to banks.

It all started when the pandemic forced the MMFs to readjust their portfolio to meet their cash outflow commitments. In the CP market, MMFs reduced their holding of CP in favor of holding risk-free assets such as government securities. In the repo market, they curtailed their repo lending both to dealers and in the cleared segment of the market. Originally, such developments were not considered a threat to financial stability. In this market, banks were regarded as the primary providers of dollar funding. The models of market-based finance, such as the one provided by Money View framework, tend to highlight banks’ function as dealers in the wholesale money market, and the main providers of funding liquidity. In these models, banks set the price of funding liquidity and earn an inside spread. Banks borrow from the interbank lending market and pay an overnight rate. They then lend the proceeds in the term-funding market (mostly through repo), and earn term rate. Further, more traditional models of bank-based financial systems depict banks as financial intermediaries between depositors and borrowers. Regardless of which model to trust, since the pandemic did not create significant disturbances in the banking system, it was expected that the banks would pick up the slack quickly after MMFs retracted from the market.

The problem is that the coronavirus casts doubt on both models, and highlights the shadowy role of banks in providing funding liquidity. The experience with the PPP loans to SMEs shows that banks are no longer traditional financial intermediaries in the retail money market. At the same time, the developments in the wholesale money market demonstrate that it is MMFs, and no longer banks, who are the primary providers of term funding and determine the price of dollar funding. A possible explanation could be that on the one hand, banks have difficulty raising overnight funding via the interbank lending market. On the other hand, their balance sheet constraints discourage them from performing their function as money market dealers and supply term funding to the rest of the financial system. The bottom line is that the pandemic has revealed that MMFs, rather than large banks, had become vital providers of US dollar funding for other banks and non-bank financial institutions. Such discoveries emphasize the instability of funding liquidity in bank-centric wholesale and retail money markets.

The withdrawals of MMFs from providing term funding to banks in the CP markets, and their decision to decease their reverse repo positions (lending cash against Treasuries as collateral) with dealers (mostly large banks), translated into a persistent increase of US dollar funding costs globally. Even though it was not surprising in the beginning to see a tension in the wholesale money market due to the withdrawal of the MMFs, the Fed was stunned by the extent of the turbulences. This is what caused the Fed to start filling the void that was created by MMFs’ withdrawal directly by creating new facilities such as MMLF. According to the BIS data, by mid-March, the cost of borrowing US funding widened to levels second only to those during the GFC even though, unlike the GFC, the banking system was not the primary source of distress. A key reason is that MMFs have come to play an essential role in determining US dollar funding both in a secured repo market and an unsecured CP market. In other words, interbank lending no longer serves as a significant source of funding for banks. Instead, non-bank institutional investors such as MMFs constitute the most critical wholesale funding providers for banks. The strength of MMFs, not the large, cash-rich, banks, has, therefore, become an essential measure of bank funding conditions.

The wide swings in dollar funding costs, caused by MMFs’ withdrawal from these markets, hampered the transmission of the Fed’s rate cuts and other facilities aimed at providing stimulus to the economy in the face of the shock. With banks’ capacity as dealers were impaired, and MMFs role was diminished, the Fed took over this function of dealer of last resort in the wholesale money market. Interestingly, the Fed acted as a dealer of last resort via its MMLF facility rather than assuming the role of banks in this market. The goal was to put an explicit floor on the CP’s price and then directly purchase three-month CP from issuers via Commercial Paper Funding Facility (CPFF). These operations also have broader implications for the future of central bank financial policies that might include MMFs rather than banks. The Fed’s choice of policies aftermath the pandemic was the unofficial acknowledgment that it is MMFs’ role, rather than banks’, that has become a crucial barometer for measuring the health of the market for dollar funding. Such revelation demands us to ask a delicate question of what precisely the banks’ function has become in the modern financial system. In other words, is it justifiable to keep providing the exclusive privilege of having access to the central bank’s balance sheet to the banks?

New Thinking in the News

These are the latest reflections from new thinkers around the on what should have been done already, what must be done next, and what the near future may look like:

1 | New Study Reveals Stark Picture of Bay Area Poverty Leading up to Covid-19 Pandemic, in Tipping Point Community, by john a. powell.

“Known for its progressive politics and rich diversity, the San Francisco Bay Area is no exception to patterns of systemic racial and economic inequality found across the nation,” said john a. powell, Director of the Othering & Belonging Institute at UC Berkeley. “In fact, the Bay Area’s hot housing market and booming economy may exacerbate these trends, making it harder for low-skilled workers to find affordable housing and pay their bills. This study, drawing upon an original survey of Bay Area residents and census data, gives us a vivid portrait of poverty and inequality, and what we should do about it, even before the COVID-19 pandemic occurred. Now this research is more urgent than ever.”

2 |30 million Americans are unemployed. Here’s how to employ them in Vox, by Pavlina Tcherneva

“But the program will actually stabilize these fluctuations. There are reasons unemployment feeds on itself. If you have this kind of preventative program, where people trickle into other employment rather than unemployment, their spending patterns are stabilized, so you have smaller fluctuations in the private sector. We see this in countries that have active labor-market policies, that do a lot more public employment than we do.”

3 | Messages from “Fiscal Space” in Project Syndicate by Jayati Ghosh

“Well before the pandemic arrived, it was evident that the financialization of the global economy was fueling massive levels of inequality and unnecessary economic volatility. In this unprecedented crisis, the need to rein it in has literally become a matter of life or death.”

4 | The ‘frugal four’ should save the European project in Social Europe by Peter Bofinger

“It is therefore crucial that the frugal four [Austria, Denmark, Sweden and the Netherlands] abandon their opposition to a joint financing facility at EU level. Only in this way will the European project be able to survive and Europe respond to this terrible crisis in a manner as effective as in the United States. For, as the US economist Paul Krugman has put it, paraphrasing Franklin Roosevelt, ‘The only fiscal thing to fear is deficit fear itself.’”

5 | Making the Best of a Post-Pandemic World, in Project Syndicate, by Dani Rodrik

“It is possible to envisage a more sensible, less intrusive model of economic globalization that focuses on areas where international cooperation truly pays off, including global public health, international environmental agreements, global tax havens, and other areas susceptible to beggar-thy-neighbor policies. Insofar as the world economy was already on a fragile, unsustainable path, COVID-19 clarifies the challenges we face and the decisions we must make. In each of these areas, policymakers have choices. Better and worse outcomes are possible. The fate of the world economy hinges not on what the virus does, but on how we choose to respond.”

6 | Two Rounds of Stimulus Were Supposed to Protect Jobs — Instead We Have Record Unemployment with Tom Ferguson in the Institute for Public Accuracy

“We all know that the U.S. response to COVID-19 has lagged far behind other countries. But now a real trap is closing. The public premise of the government stimulus programs was that they would be needed only for a short period and channeling aid to businesses would enable them to retain workers on their payrolls. So vast sums were handed out while the Federal Reserve intervened massively in financial markets. But now unemployment is soaring, in a country whose health insurance system is keyed to the workplace. Small businesses are collapsing and plainly never got much aid. Workers are also dropping out of the workforce in enormous numbers while a major health and safety crisis rages. Government policy has got to address these issues before it’s too late. It can’t simply grant blanket immunity to businesses for the sake of a hasty, premature reopening. A major re-calibration of policy is in order.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

Not such a Great Equalizer after all

Because it has no regard for borders, the coronavirus has been referred to as the Great Equalizer. But its impact is not equal by any stretch of the imagination. While China, Europe, and Northern America may recover relatively fast, emerging market economies are less resilient. The combined health, economic, and financial tolls they now endure may cause them to face the greatest recession in decades.

By Jack Gao | When COVID-19 hit, China’s strong state and centralized public administration allowed it to suppress the domestic spread. In Europe, welfare systems and appropriate policy responses made sure workers have less to worry about when economies reopen. The United States (despite Trump’s handling leaving much to be desired) enjoys a unique status of its own. The American economy and “exorbitant privilege” of the US dollar mean that policy responses can be put forth in short order, and with relatively few negative repercussions. For most emerging market economies, however, none of this can be taken for granted. The coronavirus is shaping up to be the “perfect storm” that many feared. It could sink the developing world into a deep economic recession.

No Doctors and No Food

Let’s start with public health. While the increase of new deaths in the epicenters—US, UK, Italy, Spain—appears to be slowing, the virus rages on in major developing nations. Russia, India, Mexico, and Brazil continue to report well above a thousand new daily deaths, and many of them are still on an upward trajectory. In India, a brief relaxation of the lockdown was met with a jump in deaths, underscoring that the fight to contain the virus will be an uphill battle.

Although health systems are being tested everywhere, the ones in developing countries were already under strain before COVID-19 reared its head. For example, the average number of health workers per 1000 people in OCED countries is 12.3. In the African region, this ratio is only 1.4.

As if the health crisis is not crushing enough, the United Nations warns of a “hunger pandemic” as an additional 130 million people could be pushed to the brink of starvation this year, with the vast majority of them in developing countries. The coronavirus may cross borders easily, but the suffering it causes is not equal across countries.

Locked Down and Out of Work

If the human toll of the pandemic is appalling, the economic damages to countries are unprecedented as well, as countries implement lockdown and “social distancing” to combat the virus. In the latest World Economic Outlook growth projections by the IMF, emerging market economies as a whole are expected to contract 1% this year, for the first time since the Great Depression. Literally all developing countries may be in economic decline as a result of COVID-19, with India and China eking out paltry growth. Still, these headline numbers mask the true extent of economic hardship.

Take working from home, for example. Economists have documented a clear relationship between the share of jobs that can be done at home and the national income level. In a developed country like the United States, some 37 percent of jobs can be performed at home—education, finance and IT being at the top of the scale. In some developing economies, less than 10 percent of jobs can be done remotely.

On top of all this, global remittances are collapsing. The amount of money transferred to migrants’ home countries may fall by 20 percent as workers see dwindling employment. This is terrible news for countries like Lesotho, where remittances are as much as 16% of GDP.

Where’d the money go?

The global financial system exacerbates these struggles with its core and periphery topology. During good times, foreign capital flows into emerging markets, looking for higher yields. But in bad times, when that capital is needed most, it swiftly disappears. This dynamic is now on full display. As investors started to realize the true scale of the pandemic and major central banks initiated new rounds of monetary easing, emerging economies saw capital flight as investors rushed to safer assets. An estimated 100 billion portfolio dollars fled emerging markets in the first quarter alone.

In the face of such severe dollar shortages and liquidity crunch in developing countries, the Federal Reserve had to expand central bank liquidity swaps and launch a new lending facility to come to the rescue. The impact of such international measures is still an open question. But with currency depreciation, higher borrowing costs, declining official reserves, and falling commodity prices, it appears that the financial stress emerging economies are under may be difficult to reverse.

The Triple Whammy

This way, developing countries face a health-blow, and economic-blow, and a financial-blow, all at once. An emerging market economy faced with just one of those would have resulted in a crisis. But amid COVID-19, all emerging economies were are confronted with all three crises at the same time. The damage done by this “triple whammy” could plague the developing world for years to come.

Jack Gao is a Program Economist at the Institute for New Economic Thinking. He is interested in international economics and finance, energy policy, economic development, and the Chinese economy. He previously worked in financial product and data departments in Bloomberg Singapore, and reported on Asian financial markets in Bloomberg News from Shanghai. Jack holds a MPA in International Development from Harvard Kennedy School, and a B.S. in Economics from Singapore Management University. He has published articles on China Policy Review and Harvard Kennedy School Review.

New Thinking in the News

How to respond to rising sovereign debt? What do food shortages look like now? How can we guard against data authoritarianism? This and more in this week’s collection of #NewThinkingintheNews

1 | Hunger amid plenty: how to reduce the impact of COVID-19 on the world’s most vulnerable people in Reuters, by Mari Pangestu

“It’s important to not only ensure people access basic food supplies, but also that they have money to purchase them. On average, food accounts for up to 60 percent of household expenditures in low income countries and 40 percent in emerging and development market economies. Economic recession and loss of livelihoods quickly erode the food security of millions of people – especially if food prices increase. The World Bank estimates that 40 to 60 million more people will be living in extreme poverty in coming months, depending on the scale of the economic shock.”

2 | New Laws for the Fissured Workplace in the American Prospect, by David Weil

“After this acute crisis passes, we must confront the reality that our existing workplace policies no longer account for the millions of workers with jobs (often multiple jobs) that do not fit the narrow definitions of employment embodied in federal and state laws. Today’s workforce—and those displaced from it—requires core protections linked to work, not just employment, in areas like assuring a safe and healthy workplace, receiving a minimum wage, and being protected against retaliation from exercising rights granted by our laws. This crisis also reveals the long-term need for wide access for all workers to safety-net protections like unemployment insurance and workers’ compensation as well as to comprehensive paid-leave policies that protect workers, their households, and the wider community.

3 | How to Develop a COVID-19 Vaccine for All in Project Syndicate by Mariana Mazzucato

“To succeed, the entire vaccine-innovation process, from R&D to access, must be governed by clear and transparent rules of engagement based on public-interest goals and metrics. That, in turn, will require a clear alignment between global and national public interests… But today’s proprietary science does not follow that model. Instead, it promotes secretive competition, prioritizes regulatory approval in wealthy countries over wide availability and global public-health impact, and erects barriers to technological diffusion. And, although voluntary IP pools like the one that Costa Rica has proposed to the World Health Organization can be helpful, they risk being ineffective as long as private, for-profit companies are allowed to retain control over critical technologies and data – even when these were generated with public investments.”

4 | Preventing Data Authoritarianism in Project Syndicate by Katharina Pistor

“While digital technologies once promised a new era of emancipatory politics and socio-economic inclusion, things have not turned out quite as planned. Governments and a few powerful tech firms, operating on the false pretense that data is a resource just like oil and gold, have instead built an unprecedented new regime of social control.”

5 | The Necessity of a Global Debt Standstill that Works in Project Syndicate, by Beatrice Weder di Mauro and Patrick Bolton

“Without private-sector participation, any official debt relief for middle-income countries may simply be used to service their private-sector debt. It would be pointless for the official sector to lighten poorer countries’ debt burdens if this results only in a transfer to commercial creditors… All private creditors need to participate on an equal basis in any standstill on debt service, both as a matter of fundamental fairness and to ensure adequate funding for emerging economies. And their participation cannot be purely voluntary. If it is, relief provided by participating private creditors will simply subsidize the non-participants.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

Forget about the “Corona Bond.” Should the ECB Purchase Eurozone Government Bond ETFs?

By Elham Saeidinezhad | In recent history, one of a few constants about the European Union (EU) is that it follows the U.S. footstep after any disaster. After the COVID-19 crisis, the Fed expanded the scope and duration of the Municipal Liquidity Facility (MLF) to ease the fiscal conditions of the states and the cities. The facility enables lending to states and municipalities to help manage cash flow stresses caused by the coronavirus pandemic. In a similar move, the ECB expanded its support for the virus-hit EU economies in response to the coronavirus pandemic. Initiatives such as Pandemic Emergency Purchase Programme (PEPP) allow the ECB to open the door to buy Greek sovereign bonds for the first time since the country’s sovereign debt crisis by announcing a waiver for its debt.

There the similarity ends. While the market sentiment about the Fed’s support program for municipals is very positive, a few caveats in the ECB’s program have made the Union vulnerable to a market run. Fitch has just cut Italy’s credit rating to just above junk. The problem is that unlike the U.S., the European Union is only a monetary union, and it does not have a fiscal union. The investors’ prevailing view is that the ECB is not doing enough to support governments of southern Europe, such as Spain, Italy, and Greece, who are hardest hit by the virus. Anxieties about the Union’s fiscal stability are behind repeated calls for the European Union to issue common eurozone bonds or “corona bond.” Yet, the political case, especially from Northern European countries, is firmly against such plans. Further, despite the extreme financial needs of the Southern countries, the ECB is reluctant to lift its self-imposed limits not to buy more than a third of the eligible sovereign bonds of any single country and to purchase sovereign bonds in proportion to the weight of each country’s investment in its capital. This unwillingness is also a political choice rather than an economic necessity.

It is in that context that this piece proposes the ECB to include the Eurozone government bond ETF to its asset purchasing program. Purchasing government debts via the medium of the ETFs can provide the key to the thorny dilemma that is shaking the foundation of the European Union. It can also be the right step towards creating a borrowing system that would allow poorer EU nations to take out cheap loans with the more affluent members guaranteeing the funds would be returned. The unity of EU members faces a new, painful test with the coronavirus crisis. This is why the Italian Prime Minister Guiseppe Conte warned that if the bloc fails to stand up to it, the entire project might “lose its foundations.” The ECB’s decision to purchase Eurozone sovereign debt ETFs would provide an equal opportunity for all the EU countries to meet the COVID-19 excessive financial requirements at an acceptable price. Further, compared to the corona bond, it is less politically incorrect and more common amongst the central bankers, including those at the Fed and the Bank of Japan.

In the index fund ecosystem, the ETFs are more liquid and easier to trade than the basket of underlying bonds. What lies behind this “liquidity transformation” is the different equilibrium structure and the efficiency properties in markets for these two asset classes. In other words, the dealers make markets for these assets under various market conditions. In the market for sovereign bonds, the debt that is issued by governments, especially countries with lower credit ratings, do not trade very much. So, the dealers expect to establish long positions in these bonds. Such positions expose them to the counterparty risk and the high cost of holding inventories. Higher price risk and funding costs are correlated with an increase in spreads for dealers. Higher bid-ask spreads, in turn, makes trading of sovereign debt securities, especially those issued by countries such as Italy, Spain, Portugal, and Greece, more expensive and less attractive.

On the contrary, the ETFs, including the Eurozone government bond ETFs, are considerably more tradable than the underlying bonds for at least two reasons. First, the ETF functions as the “price discovery” vehicle because this is where investors choose to transact. The economists call the ETF a price discovery vehicle since it reveals the prices that best match the buyers with the sellers. At these prices, the buying and selling quantities are just in balance, and the dealers’ profitability is maximized. According to Treynor Model, these “market prices” are the closest thing to the “fundamental value” as they balance the supply and demand. Such an equilibrium structure has implications for the dealers. The make markers in the ETFs are more likely to have a “matched book,” which means that their liabilities are the same as their assets and are hedged against the price risk. The instruments that are traded under such efficiency properties, including the ETFs, enjoy a high level of market liquidity.

Second, traders, such as asset managers, who want to sell the ETF, would not need to be worried about the underlying illiquid bonds. Long before investors require to acquire these bonds, the sponsor of the ETF, known as “authorized participants” will be buying the securities that the ETF wants to hold. Traditionally, authorized participants are large banks. They earn bid-ask spreads by providing market liquidity for these underlying securities in the secondary market or service fees collected from clients yearning to execute primary trades. Providing this service is not risk-free. Mehrling makes clear that the problem is that supporting markets in this way requires the ability to expand banks’ balance sheets on both sides, buying the unwanted assets and funding that purchase with borrowed money. The strength of banks to do that on their account is now severely limited. Despite such balance sheet constraints, by acting as “dealers of near last resort,” banks provide an additional line of defense in the risk management system of the asset managers. Banks make it less likely for the investors to end up purchasing the illiquid underlying assets.

That the alchemists have created another accident in waiting has been a fear of bond market mavens and regulators for several years. Yet, in the era of COVID-19, the alchemy of the ETF liquidity could dampen the crisis in making by boosting virus-hit countries’ financial capacity. Rising debt across Europe due to the COVID-19 crisis could imperil the sustainability of public finances. This makes Treasury bonds issued by countries such as Greece, Spain, Portugal, and Italy less tradable. Such uncertainty would increase the funding costs of external bond issuance by sovereigns. The ECB’s attempt to purchase Eurozone government bonds ETFs could partially resolve such funding problems during the crisis. Further, such operations are less risky than buying the underlying assets.

Some might argue the ETFs create an illusion of liquidity and expose the affluent members of the ECB to an unacceptably high level of defaults by the weakest members. Yet, at least two “real” elements, namely the price discovery process and the existence of authorized participants who act as the dealers of the near last resort, allows the ETFs to conduct liquidity transformation and become less risky than the underlying bonds. Passive investing sometimes is called as “worse than Marxism.” The argument is that at least communists tried to allocate resources efficiently, while index funds just blindly invest according to an arbitrary benchmark’s formula. Yet, devouring capitalism might be the most efficient way for the ECB to circumvent political obstacles and save European capitalism from itself.

New Thinking in the News

Why women are crucial to our coronavirus response, how patents impede our progress towards resolving the pandemic, and what an erosion of trust means for our society. That and more in this week’s selection of #NewThinkintheNews.

1 | America’s coronavirus response must center on women. And the Black Plague helps show how in NBC by Lynn Parramore

“Feminist scholars have long pointed out that economists, political scientists and historians tend to think of the market and the state as the key spheres of reality — while regarding the home and the family as afterthoughts. But as the changes in medieval Europe in the wake of a terrible pandemic illustrate, when women are freed from burdens in the home and gain opportunities to participate fully in all aspects of life and work, the future grows brighter for everyone.”

2 | Patents vs. the Pandemic in Project Syndicate, co-authored by Arjun Jayadev and Joseph Stiglitz

“In responding to the pandemic, the global scientific community has shown a remarkable willingness to share knowledge of potential treatments, coordinate clinical trials, develop new models transparently, and publish findings immediately. In this new climate of cooperation, it is easy to forget that commercial pharmaceutical companies have for decades been privatizing and locking up the knowledge commons by extending control over life-saving drugs through unwarranted, frivolous, or secondary patents, and by lobbying against the approval and production of generics. … It’s time for a new approach. Academics and policymakers have already come forward with many promising proposals for generating socially useful – rather than merely profitable – pharmaceutical innovation. There has never been a better time to start putting these ideas into practice.”

3 | COVID-19 and the Trust Deficit, in Project Syndicate by Mike Spence

“The problem, as we warned back in 2012, is that we are living in an era of policymaking paralysis. “Government, business, financial, and academic elites are not trusted,” we wrote. “Lack of trust in elites is probably healthy at some level, but numerous polls indicate that it is in rapid decline, which surely increases citizens’ reluctance to delegate authority to navigate an uncertain global economic environment.” Change those last words to “navigate a highly chaotic public-health and economic shock,” and the statement loses none of its relevance today.

4 | Condivergence: Thinking fast and acting slow in the pandemic war in The Edge Malaysia by Andrew Sheng

“There will be no return to the old normal. Equilibrium was going anyway with the trade war. Technology was already changing the supply chains and business models. The pandemic only destroyed the old offline big mall business model faster as everyone shifts to online business. The only problem is that most policymakers do not have the data, or the understanding as to how, to make that transition without huge costs to jobs and businesses, at least in the short run, other than to run larger deficits…. The real winners will be those who learn, adapt and innovate so that all of us emerge stronger.”

5 | The EU should issue perpetual bonds, in Project Syndicate, by George Soros

“The EU is facing a once-in-a-lifetime war against a virus that is threatening not only people’s lives, but also the very survival of the Union. If member states start protecting their national borders against even their fellow EU members, this would destroy the principle of solidarity on which the Union is built… Instead, Europe needs to resort to extraordinary measures to deal with an extraordinary situation that is hitting all of the EU’s members. This can be done without fear of setting a precedent that could justify issuing common EU debt once normalcy has been restored. Issuing bonds that carried the full faith and credit of the EU would provide a political endorsement of what the European Central Bank has already done: removed practically all the restrictions on its bond purchasing program.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

Can Central Bank Digital Currency Contain COVID-19 Crisis by Saving Small Businesses? (Part 2)

This piece is a follow up to our previous Money View article on the banking system during the COVID-19 crisis.

By Elham Saeidinezhad and Jack Krupinski |The COVID-19 crisis created numerous financial market dislocations in the U.S., including in the market for government support. The federal government’s Paycheck Protection Program offered small businesses hundreds of billions of dollars so they could keep paying employees. The program failed to a great extent. Big companies got small business relief money. The thorny problem for policymakers to solve is that the government support program is rooted in the faith that banks are willing to participate in. Banks were anticipated to act as an intermediary and transfer funds from the government to the small businesses. Yet, in the modern financial system, banks have already shifted gear away from their traditional role as a financial intermediary between surplus and deficit agents. Part l used the “Money View” and a historical lens to explain why banks are reluctant to be financial intermediaries and are more in tune with their modern function as dealers in the wholesale money markets. In Part ll, we are going to propose a possible resolution to this perplexity. In a monetary system where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most, including small and medium enterprises, who have no access to the capital market.

The history of central banking began with a simple task of managing the quantity of money. Yet, central bankers shortly faced a paradox between managing “survival constraint” in the financial market and the real economy. On the one hand, for banks, the survival constraint in the financial market takes the concrete form of a “reserve constraint” because banks settle net payments using their reserve accounts at the central bank. On the other hand, according to the monetarist idea, for money to have a real purchasing power in terms of goods and services, it should be scarce. Developed by the classical economists in the nineteenth and early twentieth centuries, the quantity theory of money asserted that the quantity of money should only reflect the level of transactions in the real economy.

The hybridity between the payment system and the central bank money created such a practical dilemma. Monetarist idea disregarded such hybridity and demanded that the central bank abandon its concern about the financial market and focus only on controlling the never-materializing threat of inflation. The monetarist idea was doomed to failure for its conjectures about the financial market, and its illusion of inflation. In the race to dominate the whole economy, an efficiently functioning financial market soon became a pre-condition to economic growth. In such a circumstance, the central bank must inject reserves or else risk a breakdown of the payments system. Any ambiguity about the liquidity problems (the survival constraint) for highly leveraged financial institutions would undermine central banks’ authority to maintain the monetary and financial stability for the whole economy. For highly leveraged institutions, with financial liabilities many times larger than their capital base, it doesn’t take much of a write-down to produce technical insolvency.

This essential hybridity, and the binding reality of reserve constraint, gave birth to two parallel phenomena. In the public sphere, the urge to control the scarce reserves originated monetary policy. The advantage that the central bank had over the financial system arose ultimately from the fact that a bank that does not have sufficient funds to make a payment must borrow from the central bank. Central bankers recognized that they could use this scarcity to affect the price of money, the interest rate, in the banking system. It is the central bank’s control over the price and availability of funds at this moment of necessity that is the source of its control over the financial system. The central bank started to utilize its balance sheet to impose discipline when there was an excess supply of money, and to offer elasticity when the shortage of cash is imposing excessive discipline. But ultimately central bank was small relative to the system it engages. Because the central bank was not all-powerful, it must choose its policy intervention carefully, with a full appreciation of the origins of the instability that it is trying to counter. Such difficult tasks motivated people to call central banking as the “art,” rather than the “science”.

In the private domain, the scarcity of central bank money significantly increased the reliance on the banking system liabilities. By acting as a special kind of intermediary, banks rose to the challenge of providing funding liquidity to the real economy. Their financial intermediation role also enabled them to establish the retail payment system. For a long time, the banking system’s major task was to manage this relationship between the (retail) payment system and the quantity of money. To do so, they transferred the funds from the surplus agents to the deficit agents and absorbed the imbalances into their own balance sheets. To strike a balance between the payment obligations, and the quantity of money, banks started to create their private money, which is called credit. Banks recognized that insufficient liquidity could lead to a cascade of missed payments and the failure of the payment system as a whole.

For a while, banks’ adoption of the intermediary role appeared to provide a partial solution to the puzzle faced by the central bankers. Banks’ traditional role, as a financial intermediary and providers of indirect finance, connected them with the retail depositors. In the process, they offered a retail payment- usually involve transactions between two consumers, between consumers and small businesses, or between two small to medium enterprises. In this brave new world, managing the payment services in the financial system became analogous to the management of the economy as a whole.

Most recently, the COVID-19 crisis has tested this partial equilibrium again. In the aftermath of the COVID-19 outbreak, both the Fed and the U.S. Treasury coordinated their fiscal and monetary actions to support small businesses and keep them afloat in this challenging time. So far, a design flaw at the heart of the CARES Act, which is an over-reliance on the banking system to transfer these funds to small businesses, has created a disappointing result. This failure caught central bankers and the governments by surprise and revealed a fatal flaw in their support packages. At the heart of this misunderstanding is the fact that banks have already switched their business models to reflect a payment system that has been divided into two parts: wholesale and retail. Banks have changed the gear towards providing wholesale payment-those made between financial institutions (e.g., banks, pension funds, insurance companies) and/or large (often multinational) corporations- and away from retail payment. They are so taken with their new functions as dealers in the money market and originators of asset-backed securities in the modern market-based finance that their traditional role of being a financial intermediary has become a less important part of their activities. In other words, by design, small businesses could not get the aid money as banks are not willing to use their balance sheets to lend to these small enterprises anymore.

In this context, the broader access to central bank money by small businesses could create new opportunities for retail payments and the way the central bank maintains monetary and financial stability. Currently, households and (non-financial) companies are only able to use central bank money in the form of banknotes. Central bank digital currency (CBDC) would enable them to hold central bank money in electronic form and use it to make payments. This would increase the availability and utility of central bank money, allowing it to be used in a much more extensive range of situations than physical cash. Central bank money (whether cash, central bank reserves or potentially CBDC) plays a fundamental role in supporting monetary and financial stability by acting as a risk-free form of money that provides the ultimate means of settlement for all sterling payments in the economy. This means that the introduction of CBDC could enhance the way the central bank maintains monetary and financial stability by providing a new form of central bank money and new payment infrastructure. This could have a range of benefits, including strengthening the pass-through of monetary policy changes to the broader economy, especially to small businesses and other retail depositors, and increasing the resilience of the payment system.

This increased availability of central bank money is likely to lead to some substitution away from the forms of payment currently used by households and businesses (i.e., cash and bank deposits). If this substitution was extensive, it could reduce the reliance on commercial bank funding, and the level of credit that banks could provide as CBDC would automatically give access to central bank money to non-banks. This would potentially be useful in conducting an unconventional monetary policy. For example, the COVID-19 precipitated increased demand for dollars both domestically and internationally. Small businesses in the U.S. are increasingly looking for liquidity through programs such as the Paycheck Protection Program Liquidity Facility (PPPLF) so that those businesses can keep workers employed. In the global dollar funding market, central banks swap lines with the Fed sent dollars into other countries, but transferring those dollars to end-users would be even easier for central banks if they could bypass the commercial banking system.

Further, CBDC can be used as intraday liquidity by its holders, whereas liquidity-absorbing instruments cannot achieve the same, or can do so only imperfectly. At the moment, there is no other short-term money market instrument featuring the liquidity and creditworthiness of CBDC. The central bank would thus use its comparative advantage as a liquidity provider when issuing CBDC. The introduction of CBDC could also decrease liquidity risk because any agent could immediately settle obligations to pay with the highest form of money.

If individuals can hold current accounts with the central bank, why would anyone hold an account with high st commercial banks? Banks can still offer other services that a CBDC account may not provide (e.g., overdrafts, credit facilities, etc.). Moreover, the rates offered on deposits by banks would likely increase to retain customers. Consumer banking preferences tend to be sticky, so even with the availability of CBDC, people will probably trust the commercial banking system enough to keep deposits in their bank. However, in times of crisis, when people flee for the highest form of money (central bank money), “digital runs” on banks could cause problems. The central bank would likely have to increase lending to commercial banks or expand open market operations to sustain an adequate level of reserves. This would ultimately affect the size and composition of balance sheets for both central banks and commercial banks, and it would force central banks to take a more active role in the economy, for better or worse.

As part 1 pointed out, banks are already reluctant to play the traditional role of financial intermediary. The addition of CBDC would likely cause people to substitute away from bank deposits, further reducing the reliance on commercial banks as intermediaries. CBDC poses some risks (e.g., disintermediation, digital bank runs, cybersecurity), but it would offer some new channels through which to conduct unconventional monetary policy. For example, the interest paid on CBDC could put an effective floor on money market rates. Because CBDC is risk-free (i.e., at the top of the money hierarchy), it would be preferred to other short-term debt instruments unless the yields of these instruments increased. While less reliance on banks by small businesses would contract bank funding, banks would also have more balance sheet freedom to engage in “market-making” operations, improving market liquidity. More importantly, it creates a direct liquidity channel between the central banks, such as the Fed, and non-bank institutions such as small and medium enterprises. Because central banks need not be motivated by profit, they could pay interest on CBDC without imposing fees and minimum balance requirements that profit-seeking banks employ (in general, providing a payment system is unprofitable, so banks extort profit wherever possible). In a sense, CBDC would be the manifestation of money as a public good. Everyone would have ready access to a risk-free store of value, which is especially relevant in the uncertain economic times precipitated by the COVID-19.

Jack Krupinski is a student at UCLA, studying Mathematics and Economics. He is pursuing an actuarial associateship and is working to develop a statistical understanding of risk. Jack’s economic research interests involve using the “Money View” and empirical methods to analyze international finance and monetary policy.