Story Stream
recent articles

Weird doesn’t even begin to describe it. You are a hedge fund, let’s say, and your business is buying risky longer-term bonds leveraging a menu of short-term funding options. Typical maturity transformation stuff. To obtain the most efficient leverage, the lowest cost, least friction funding, you want to post good quality collateral.

You don’t have any.

Not to worry, the bank you happen to be working with and which is absolutely dying to lend in repo to you has endless access to the best securities you could ever want. Better still, the place absolutely wants you to borrow its collateral so that you can then turn around and post the same you just borrowed right back to it.

Once you do, the lending goes through.

Confused? Welcome to the Japanese end of eurodollar life. Rather than taking this idea from some monetary equivalent science fiction universe, like you may be thinking, we need only reference official Bank of Japan documents from the year 2016. In them, what I just described is itself described this way:

“The Bank [of Japan] will establish a new facility in which it lends Japanese government securities (JGSs) to financial institutions against their current account balances with the Bank so that these JGSs can be pledged as collateral for the U.S. Dollar Funds-Supplying Operations.”

So, basically, a self-referential collateral transformation. The current account balance is a reserve asset largely created by QE’s. That’s not really the important part, not for our or anybody else’s purposes. The key comes in at the end of the passage: “U.S. Dollar Funds-Supplying Operations.”

It’s not quite hedge funds rather Japanese banking institutions and they aren’t transacting with some overly-generous random broker, instead the Bank of Japan.

Japanese banks, however, are little more than speculative hedge funds, at least when it comes to their operations outside of Japan. Among their favored investment targets, those dollar-hungry behemoths standing around in China.

From early on in the post-2008 era, Tokyo was somewhat reborn as a crucial redistribution center for a less-eurodollar, more Asian-dollar world. It wasn’t nearly the same global scale as 1995 to 2007, but sufficient to keep emerging markets like China relatively supplied in the aftermath of that first global spasm.

Why Japan for China? Two reasons, really. First, the Japanese banks had essentially been transformed into pristine balance sheets without the hint of a risk on any of them (to Japan’s monetary, financial, and economic detriment; even Keynes knew a healthy economy absolutely requires “animal spirits”). Another way of saying the same thing is they had enormous potential capacity but nothing useful to do with it.

The second factor here, really there, was how Japanese banks had grown uniquely familiar with the Chinese financial landscape in a way few other had or have. In doing so, they then became accepted or at least judged acceptable by the typically overzealous monetary gatekeepers throughout China.

Such cultural fluency had been bred by the former practice of vertical integration among Japan’s major conglomerates. As the industrial businesses moved deeper into China during Deng’s years, geographically as well as in real economy projects, they naturally introduced their financial heft to the Chinese as they did. I wrote in late 2015 (for the very same reasons as I bring this back up today):

“That suggests that as Japanese formerly keiretsu penetrated further into mainland China, they likely brought with them their banking ‘core.’ At the very least, Japanese banks with close ties to these offshoring Japanese firms were likely introduced to Chinese industrial counterparts.”

Things were different on the other side of 2008’s Global Financial Crisis in the respect of who was trustworthy to do dollar business with; from both sides. Western firms had proved unreliable given the fact many could barely stay in business. You don’t want to have to depend upon those jokers who might reasonably lend you dollars one day only to turn around the next and demand exorbitant premiums for the same thing because of their own inhouse issues.

By and large, the Japanese banks cleaned those up in the late 90’s, early 2000’s.

All that was necessary had been the opportunity, one that had always existed from the Chinese side of the ledger.

For all the bluster otherwise over the years, the plain truth is that China, as everyone else (including, ahem, Russia), needs US dollar funding. They don’t get it from the US, however, (also, ahem, Russia), rather the offshore eurodollar funding apparatus which is a complicated beast of sometimes competing interests contained within a web of oftentimes confusing transaction varieties.

The world needs these “dollars” because that is, as of right now and the far foreseeable future, the only way to conduct necessary, lifegiving business around the world. A Chinese firm needing raw material from Australia? That import company might be able to find some Aussie dollars to pay for it, but transacting that way in the one’s local currency would be expensive, likely unprofitable.

Instead, when the whole world is using the same currency mediating practically everything in between, that currency is readily available on both sides of the trade. The Chinese firm can cheaply transact with a Chinese bank to secure US dollars to transfer to the Australian supplier’s Australian bank (which can then reuse by supplying an Australian importer seeking to buy goods from somewhere else on the planet besides China).

Everyone is happy.

Unless, of course, the Chinese bank which supplied the US dollars to the import firm suddenly itself can’t secure US dollars to use. This becomes a huge problem for that bank, for China’s import economy, as well as Australia, too.  

This overly simplified illustration accurately enough describes the Chinese predicament circa 2009. Enter the Japanese.

From the perspective of the big Tokyo banks already introduced to China, there seemed initially very, very little risk in stepping in to supply what so many “troubled” Western banks no longer would in the same way as before August 2007 (and for Asia, the eurodollar funding hit came in July 2008).

These Japanese firms merely had to post some form of security along with their good standing reputations (as basically pristine financial utilities) to stand in between former partners; rather than lending going from Western banks straight into China, from 2009 forward much would reroute into Tokyo first.

And for years this was called a “carry trade.”

This made eurodollar banks more willing to do something if that something was done with a Japanese counterparty. That same Japanese counterparty could then conduct maturity transformation into China in some form or another, reducing liquidity risk from the rest of the eurodollar system by putting it more squarely on the shoulders of Japan’s calculating risk-takers.

Why would the Japanese do this? Their balance sheets and post-90s reputations what they were, many saw it as low liquidity risk at the same time as huge opportunity to fill in the vacuum where China was concerned. Their (fatal) conceit was emerging markets emerging from the Great “Recession” unscathed while Europe and the United States (along with European and American banks) suffered under a “new normal.”

These assumptions began to unravel rather quickly, in 2011 and 2012 actually. During those years, particularly crisis-filled December 2011 and January 2012, Japanese banks were back to accessing the Federal Reserve’s overseas dollar swaps in amounts nearly rivaling 2008.

Yet, by all accounts, the Japanese emerged from it somewhat undeterred when it came to their perceived favorable Chinese asymmetry. It wasn’t until the full gravity of that second global eurodollar crisis began to register, in China, too, that things truly started to go awry.

Part of the issue always stems from collateral scarcity, both as a post-2008 background deficiency as well as in these repeated recurrences. Everyone is borrowing collateral as well as cash, sometimes the collateral borrowing is itself collateralized by other forms of collateral.

At root of much of this complexity is the US Treasury; as in, securities rather than the government institution squarely focused on financing the ridiculously huge federal government’s deficits by issuing what the monetary system views as the most highly prized form of currency. In this other sense, the brokest government in human history can finance its own debt via this form of deflationary monetary disease (but I digress).

What might happen if previously good standing Japanese banks redistributing eurodollars into China were looked upon as if refunding dollars for China might be riskier than previously thought? Rather than reputation alone, eurodollar suppliers might suddenly demand some more security; and by that I mean less variety of securities, more safe and liquid than anything else.

The scramble for collateral along with a general and growing scarcity of it only makes eurodollar suppliers more averse to continue their supplies on the same terms. If I’m one of them and I know you as a Japanese eurodollar redistributor aren’t easily able to secure collateral security, we’re going to have an increasingly difficult time staying in business together.

That shuts off reliable eurodollar funding from Japan, and anyone else further down the line.

This is, therefore, the perfect point by which to circle back to the Bank of Japan in 2016 for a second look at what by now might (I hope) seem a touch less ridiculous.

In response to another, the third global dollar shortage (2014-15), including collateral scarcity, the Bank of Japan in July 2016 comes up with a dollar-funding scheme which basically creates dollar-useful collateral out of its own gargantuan holdings of JGBs (or JGS, using the Bank’s terminology).

BoJ wasn’t then, or now, really planning on any of its banks actually using this new program, merely trying to reassure the eurodollar system at large that, push comes to shove, Japanese banks will never be completely cut off from “dollars” for any reason including lack of collateral. At the beginning of any day, they could borrow JGS from BoJ, post it right back to Japan’s central bank, who then swaps for “dollars” with FRBNY on their behalf.

I need to also point out here that there are no dollars used in any physical or tangible sense; everything including the collateral swaps, at BoJ or hidden in the shadows of the eurodollar system, are only ever book entries (ledger). Therefore, “dollars.”

As you may have heard recently, both the Japanese yen and Chinese yuan are, contrary to many if not most mainstream expectations, absolutely plunging. The yen reached a new two-decade low this week, while China’s currency tumbled to its worst since November 2020 after having previously defied the growing funding problems from last year.

The dollar’s exchange value is once more rising precipitously in light of what I just wrote, and what markets have been pricing all along. Global “dollar” shortage. Eurodollar squeeze. Much of it related to collateral scarcity.

This is why, for example, you can, right now, plot JPY over the past two years against US$ repo fails reported by primary dealers in that same timeframe and both of them come out as near exact copies of each other. The higher (or lower) fails go, the lower (or higher) JPY trends. In recent weeks, repo fails have spiked; the yen has collapsed.

Repo fails are, of course, a reasonable proxy for systemic collateral sufficiency when fails are low; or, systemic scarcity should fails come in high. The latter, in particular, affects general funding conditions as well as, the point of this article, eurodollar funding related to Japan’s redistribution links with China.

Japanese officials had basically admitted this was a potential weakness way back in 2016 when first devising their borrow-it-from-me-give-it-right-back-to-me collateral plan. The plan itself, again, wasn’t meant to actually fix the problem or fill in for a real-world shortfall; instead, the most absurd part about it was the belief, maybe just hope it might sway eurodollar counterparties more favorably when the time came.

The time has come. No one seems swayed as collateral predictably grows increasingly scarce, especially since the end of February. The entire financial system plunged into relative chaos around March’s regular seasonal low point, if not quite crisis-level chaos, with the effects, and the trend, dangerously still intact as I type this.  

Therefore, both Japan’s and China’s currencies tank on the opposite side from the dollar rampaging again as a reflection of an acute shortage of “dollars” currently. Japanese banks having trouble getting, keeping, re-using collateral, so what’s left for China? Hope that the 2016 plan suddenly makes a marginal case to some eurodollar funding agent somewhere.

Good luck with that.

Risk aversion. Collateral shortage. Rising dollar exchange value. Inflation? Nope. The convoluted official Japanese acknowledgement notwithstanding, these things never change. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

Show comments Hide Comments