>> The law of "universal gravitation" in the foreign exchange market---CIP
What are CIPs? In fact, it is the law of one price of financial assets. This law was first proposed by Friedman in the 1950s. How to understand?
If you sell a hamburger for one dollar in the United States, you should sell it for 6 yuan in China, because the ratio of the dollar to the renminbi is 6.8. In fact, the final price of any same commodity in any country should be the same if there is no loss. One dollar in China is 6.8, it is the same thing anyway, this is called the law of one price.
Similarly, as long as financial assets are placed in China, the United States, or other places, as long as they are of the same type, with the same credit rating standards, etc., their returns should be the same. This is the law of one price, a kind of financial asset in the middle For special applications, this relationship is called CIP.
They must be the same. If they are not the same, there is a problem, and we say that the law of CIP has been broken. To explain this concept in depth, assuming that the currency can flow freely across borders without cost, then the savings income obtained by a fund in the country is converted into the currency of another country, within the same period and at different interest rates The total return on foreign currency savings obtained under these conditions should be exactly the same as the total return on converting the foreign currency total return to the local currency.
It's a bit confusing, but it should be understandable. For example, if you have 1 dollar of funds, you buy 1 dollar of treasury bonds in the United States and exchange this dollar for 6.8 yuan to buy such treasury bonds in China with different interest rates than those of the United States, and then use the proceeds of the treasury bonds in the end Converted back to USD, it should be consistent in the end. It's a bit convoluted, but in fact this is the concept of the law of one price.
If the following laws are satisfied, CIP should be in an ideal state without arbitrage, that is, currency cross-border investment in similar assets, and the interest rate difference will be completely offset by the exchange rate difference. No room for arbitrage,
For example, the RMB interest rate is high, while the US interest rate is low, investing in RMB treasury bonds seems to make more money, but in fact the difference in exchange rate will offset the difference in interest rate, there is no room for arbitrage, and no money can be made.
If there is room for arbitrage, a large amount of funds will automatically flow into the market for arbitrage, and the interest rate and exchange rate differences will soon be eliminated, and the state of interest rate parity will be restored. This is the core concept of CIP.
All changes in the foreign exchange market revolve around CIP, which must be deeply understood. It's actually a very simple concept: the law of one price for financial assets in financial markets.
>> The mystery of CIP's long-term "arbitrage"
What is happening now is that CIP is in arbitrageable state for a long time, as we can clearly see from this picture. If the CIP is deflected, it will be reflected in the basis of the currency basis swap, that is, the US dollar handling fee. It can be seen that it is obviously below zero, which is called a negative value.
From 2001 to the present, the currency of major countries, such as the Japanese yen, such as the Hong Kong dollar, the euro, etc., compared with the US dollar, most of the currency bases are negative. What does it mean?
It shows that the currencies of these countries are more scarce than the U.S. dollar, so if the currencies of these countries are converted into U.S. dollars, a scarcity fee must be paid to the U.S. dollar.
Only a few countries such as Australia and New Zealand have currencies that are scarcer than the US dollar. The reason is another reason, which will be discussed in a moment.
Then through this picture, we can actually see that after 2008, there have been three peak periods of negative basis in the world.
The first time was during the crisis in 2008. We could see that currencies like the Japanese Yen had a negative negative value of more than 100 points. As long as there is a financial crisis, there will be a shortage of dollars, because the entire financial system and overseas foreign exchange financial systems will be seriously short of dollars, and the supply of dollars will be cut off, so everyone will grab dollars.
The second peak was the European debt crisis in 2012.
The third peak was in July 2014. After the circulation of the dollar reversed, the dollar became scarce again.
The three consecutive peaks of dollar scarcity have lasted for 12 consecutive years since the financial crisis until this year. When major national currencies in the world borrow dollars, they must pay an additional scarcity fee to the dollar.
>> CIP failure
Why does this phenomenon occur? It stands to reason that as long as the CIP deviates to 0, arbitrage funds will come in and pull this line back to 0. Why didn't the arbitrage funds pull it back? Why does the law of universal gravitation fail? Since there is such a large risk-free arbitrage opportunity, and the opportunity is becoming more and more obvious, why is no one taking advantage of this arbitrage opportunity?
Let's put this question aside for a moment. First, let's look at why there is a dollar shortage during the financial crisis? What needs to be known is that there are also types of dollar shortages, including acute dollar shortages and chronic dollar shortages.
>> Acute dollar shortage: financial turmoil
I believe everyone will be familiar with the series of measures taken by the United States in March 2020. Whether it is the monetary policy of the Federal Reserve, the 2 trillion fiscal stimulus bill of the Ministry of Finance, or a series of other operations, why does the United States do this? First of all, there is a problem with the banking system in the United States. A large number of companies have no money and cannot issue commercial paper. They can only use bank deposits and transfer the funds in the bank to their company accounts in the bank. The money is still in the bank, but theoretically the money no longer belongs to the bank.
That has weighed on Bank of America's balance sheets. There is not enough money, the balance sheet is not enough to allow the banks to continue to expand, and the banks have lost their ability to credit. At the same time, when a bank encounters a crisis, the mutual trust between the bank and the bank will also decline, and they are unwilling to lend funds.
So we look at the basis deterioration, what happens? When the financial crisis broke out, international banks were worried about the above-mentioned risks, and U.S. dollar lending was extremely shrinking (banks stopped lending money). At the same time, companies took credit lines from U.S. banks and hoarded cash. Willing to lend, but also unable to lend.
The source of the dollar is cut off from the bank. (The crossed places in the figure below all indicate that the source of the dollar has been cut off)
In March 2020, a large-scale monetary fund was evacuated, and no money was provided to the money market. This channel was cut off, so the money market was frozen, and commercial paper time deposit certificates could not be issued.
Overseas banks, such as those in Japan, Singapore, and Hong Kong, originally used the US money market for direct financing, but now they cannot issue bills, and no one buys time deposit certificates. This channel of funds leading to overseas has also been cut off. , And this has led to the entire foreign exchange market's source of dollars being cut off, there has been an acute cut-off of dollar supply, or the sudden depletion of the source of dollar supply, which will lead to an extreme shortage of dollars in the foreign exchange market.
Next, interest rates are bound to soar. So we will see the difference between forward rate (FRA) and OIS. (IOS represents the central interest rate in the U.S. money market, while the forward interest rate is the expectation of Libor.) This shows that there is also a serious dollar shortage in the overseas dollar market. The difference is worsened by negative values.
After the financial nuclear explosion in the United States on March 20th, looking at the exchange rates of various countries, the Japanese yen against the US dollar, the euro against the US dollar, including the British pound, all experienced a large-scale negative basis difference, that is, the appreciation of the US dollar .
And these countries have to pay very high fees to the US dollar, exaggerated such as the Japanese yen, need to pay an additional 150 basis points in order to borrow US dollars.
The negative value of the basis has reached such an extent, which shows that there is an extreme shortage of US dollars in the market. What is the reason? That is, all sources of supply of dollars are cut off, a large amount of dollars is needed in the market, and a huge amount of dollars is required to roll every day.
This illustrates a phenomenon: there will be a dollar shortage during a financial crisis. Because the source of the US dollar will be cut off, the exchange rate will be in chaos, including the interest rate market. The overseas dollar market will be chaotic.
>> Chronic dollar shortage: imbalance between supply and demand
So what about the chronic dollar shortage? In fact, it is easy to understand, mainly because of the imbalance between supply and demand.
The picture below is a basis map from 2013 to 2016. The red line represents the basis difference between the US dollar and the euro, and the blue line is the basis difference between the US dollar and the yen.
It can be seen that there is an obvious reversal point in 2014. This time node happens to be the reversal point of the US dollar circulation. Once the reversal point occurs, whether it is for the euro or the yen, the situation of the basis difference becoming negative becomes more and more serious. Explain what? It shows that there was a relatively serious chronic dollar shortage during this time period.
Therefore, we need to understand what is called a chronic dollar shortage from two aspects of supply and demand.
>> Supply
Let’s start with the dollar supply. The dollar supply is tightening for three reasons:
The first reason is Walker's Law. The Volcker Law is mainly aimed at strengthening the supervision of large international banks, and these large international banks are mainly market makers in the foreign exchange market.
For example, changing the leverage ratio, or changing the calculation of risk weights, etc., will increase the burden on these large international banks. When they expand their balance sheets, the cost will increase.
Therefore, as foreign exchange market makers, they are unwilling to make the market and provide trading services for the market. The liquidity of the foreign exchange market will decrease, and the spread between the bid price and the ask price will expand.
If the market maker does not make the market, you will not be able to find a counterparty at all, or it will be difficult to find a counterparty. This leads to the fact that although many people want to arbitrage, they have no way or ability to pull this curve up. This arbitrage It is very difficult to do, which is an important reason why the CIP curve did not rebound to 0. (This is exactly the answer to the above CIP invalidation question)
The second reason is that Bank of America's business model has changed. In 2014, the U.S. dollar entered a cold circulation, and the negative value of the basis value became deeper and deeper, while the U.S. dollar appreciated.
And because U.S. banks have investments all over the world and have a large number of foreign currency assets, these assets will face depreciation pressure due to the appreciation of the US dollar, and the depreciation pressure will be warned by the Volcker Law. Therefore, under this new regulatory bill, those banks have no choice but to shrink overseas credit in US dollars.
That is to say, the more the US dollar appreciates, the less you dare to lend overseas, because the loaned money becomes foreign currency assets. As a result, the foreign currency assets depreciate under the appreciation of the US dollar, which will directly put serious pressure on the bank's balance sheet.
The third is the reversal of the dollar. After the circulation reversed, the U.S. dollar appreciated, and the prices of commodities and oil plummeted. As a result, the formerly wealthy emerging market countries became poorer and lost their U.S. dollar reserves.
Because of the depreciation of their local currency, they need to sell US dollars to stabilize their currency value, so their foreign exchange reserves continue to drain, and their sovereign wealth funds will also shrink, so this further reduces the source of US dollar supply in the foreign exchange market.
As a result, the supply of dollars will be found to be getting tighter and tighter in all directions.
>> demand
After talking about the supply of dollars, let’s talk about the demand for dollars. But before talking about the needs, let's talk about a digression and make a foreshadowing.
After the dollar circulation reverses (from hot circulation to cold circulation), the dollar index rises, which will naturally lead to a scarcity of dollars.
In the picture above (on the left), the red line is the U.S. dollar index, and the blue line is the external loans of US banks. What is the rule of these two lines?
As long as the U.S. dollar index weakens, U.S. banks’ overseas U.S. dollar lending will rise; on the contrary, if the U.S. dollar index rises and the U.S. dollar appreciates, U.S. banks’ overseas loans will decline, and the two are inversely proportional.
The main reason is that U.S. banks will hesitate to lend in U.S. dollars when the U.S. dollar appreciates, mainly to avoid the depreciation of foreign currency assets caused by the exchange rate, which will affect the balance sheet and put pressure on the bank's lending capacity.
Look at the figure above (on the right), the U.S. dollar index and the currency swap basis. The red line is the U.S. dollar index, and the blue line is the currency swap basis. The higher the dollar index, the more negative the currency swap basis will be. What does this mean? It shows that the cost of borrowing US dollars is even greater.
The global dollar is in a state of chronic scarcity. This picture explains the principle just mentioned very well.
Well, the foreshadowing is done, back to the topic of dollar demand. Dollars have different needs
>> First demand
The first requirement is overseas banks. It has two major mismatches (currency mismatch and asset maturity mismatch), and the two major mismatches will generate risks, which must be effectively hedged. Therefore, the greater the amount of US dollar assets and liabilities held by overseas banks, the more risk hedging is required. (If you don’t understand the two major mismatches, please read down patiently and give a detailed explanation)
The graph above is the assets and liabilities of non-U.S. cross-border banks denominated in U.S. dollars. For example, Bank of China, Bank of Japan, European Bank, etc. How many dollar-denominated assets do these banks hold?
From 2000 to 2019, you can see all the total assets. 0 is an asset at the top and a liability at the bottom. We can see the assets and liabilities holding US dollars, just like the shape of the trumpet is getting bigger and bigger, that is, the assets and liabilities are increasing at the same time.
Some countries and some regions are in the state of net assets in US dollars, and some are in the state of net liabilities. As mentioned above, due to the US foreign exchange market makers, those large international banks are passively slowing down due to the regulation of Volcker's law. At the same time, the credit of U.S. banks has tightened due to the appreciation of the U.S. dollar, making it impossible for overseas banks in China, Japan, South Korea, and Europe to rely on loans from traditional foreign exchange market makers and U.S. banks. As a result, they are forced to Increasingly dependent on the US money market.
We also mentioned earlier that the Bank of Japan issued a large number of bills and certificates of deposit in the U.S. money market, all in order to obtain short-term U.S. dollars. Of course, they can also obtain short-term US dollar financing through swaps in the foreign exchange market, which will exacerbate the two major risks of currency mismatch and asset maturity mismatch.
What does that mean? For example, the Bank of Japan lends US dollars to invest in China and Southeast Asia. The money that the Japanese bank lends out is in US dollars, but the local cash flow generated by the return on investment is in RMB or the currencies of those countries in Southeast Asia. This creates a currency mismatch, with banks lending in dollars and investing returns in non-dollars. This is risky for banks.
In addition, the U.S. dollars held by the Bank of Japan are not earned through trade in many cases, but the Bank of Japan first converts a large amount of yen savings into U.S. dollars through foreign exchange swaps, and then invests U.S. dollars in China, Southeast Asia and other places .
Therefore, it is necessary to operate several times through foreign exchange swaps, that is to say, this is a series of foreign exchange swaps, which creates an obvious risk of currency mismatch, which must be hedged. If there is no hedging, the exchange rate market will fluctuate greatly, and you will suffer heavy losses.
At the same time, many projects are long-term, such as investing in the Three Gorges Dam, investing in real estate, etc., often lasting several years to decades. And what about dollar financing? Since it cannot be obtained from other sources, it can only rely on short-term financing, so the financing period is 7 days or less. Like investing in real estate, it often takes several years. This is called term mismatch.
With short financing periods and long-term assets, these overseas banks have to do a lot of risk hedging in the foreign exchange market, thus increasing the demand for US dollars.
No matter how you hedge, you have to use US dollars. The larger the amount of hedging, the greater the amount of US dollars you need.
If you don’t understand the foreign exchange market in depth, you can’t understand why Japan needs so many U.S. dollars, because its U.S. dollar assets and liabilities are too large. To protect these assets and liabilities, you need a lot of U.S. dollars to operate in the foreign exchange market. Either risk hedging, or rolling financing, or arbitrage, these actions will increase the demand for dollars.
Likewise, if the balance sheets of overseas banks continue to expand, more dollars will be needed.
In fact, it can be seen from this picture that the central part is Asia, and Europe has become smaller and smaller. Now the Asian region has replaced the European region, which means that the Asian region has become the region with the most US dollar assets and liabilities.
The advantage is that the scale of U.S. dollar assets is getting bigger and bigger. The disadvantage is that the larger the U.S. dollar assets, the more the need for U.S. dollars, and if they are not met, it will lead to a serious financial crisis, so huge risks have accumulated.
Therefore, non-US banks around the world need large-scale US dollar financing in order to hedge the two major mismatch risks. The greater the volume of dollar-denominated assets, the more dollars the world needs.
In recent years, there have always been voices saying that the importance of the U.S. dollar has become less and less, on the grounds that the U.S. dollar’s share of international reserves has been declining year by year. wrong! ! ! You have to look at the foreign exchange market, which is many times larger than foreign exchange reserves.
People's reliance on dollars is increasing day by day from the volume of foreign exchange transactions. This system is a very clever system. The more dollars you have, the more you need dollars. Just like a big fat man, the heavier you are, the more you need to eat. The more stuff, the more stuff you eat and the heavier you get, it's a vicious cycle.
>> Second demand
The second major direction of dollar demand is that multinational companies want to carry out interest rate arbitrage financing. The picture below (left one) is the corporate credit spread (that is, the difference in credit) between the euro zone and the US dollar zone. The red line is the euro zone company, and the yellow line is the US company. It can be seen that the euro companies are obviously low, why?
Because the euro zone is doing large-scale quantitative easing, and the United States has scaled down its balance sheet and stopped QE. Therefore, due to quantitative easing, the European Central Bank prints money to buy corporate bonds, which will lower the rate of return of companies and reduce credit risks. This caused credit spreads to widen. It is easier and cheaper for European companies to issue debt.
At the same time, the foreign exchange basis has also changed (the second from the left in the figure). FX basis spreads are becoming increasingly negative.
The larger the interest rate differential between the United States and Europe, the more negative the basis value becomes. What does this mean?
Explain the need for more dollars in the market. The picture (first on the right) shows the issuance of euro debt by US companies (ordinary US companies that are not financial institutions). This is very interesting. American companies went to the euro zone to issue bonds. Why? Because of the low cost of the euro. If you look at credit spreads, if you issue debt in the euro area, the interest rate will be more favorable than in the United States.
You must know that issuing US dollar bonds in the United States needs to be calculated. Since the euro zone is more favorable, why not issue it in the euro zone? This led to the emergence of a very interesting financial product called inverse Yankee bonds.
What are Inverse Yankee Bonds? It was after the European debt crisis and the reversal of the dollar circulation that the monetary policies of the two regions began to diverge. The United States shrinks its balance sheet and raises interest rates, and the euro zone increases easing, so the credit spread of euro bonds is lower than that of the dollar. It is for this reason that American companies use the interest rate difference between Europe and the United States to carry out arbitrage financing.
How to arbitrage? American companies went to Europe to issue euro bonds, and then exchanged the obtained euros for U.S. dollars by currency basis, and paid Libor interest in U.S. dollars regularly.
Note that the US company is now standing on the euro, so it has to pay interest in dollars to the risk counterparty, and what it receives is the euro Libor + basis, and this basis is negative because the dollar is more scarce. After the bond matures, the U.S. dollar is exchanged back to the euro to pay off the debt issued in Europe.
Therefore, the average maturity of reverse Yankee bonds is very long. There are many 10-year, 15-year, and even 20-year bonds, and there are even longer ones. The only thing that changes in the middle is the interest rate. This is the hottest type of financing in the past few years.
Multinational corporations take advantage of the different interest rate policies of various countries to carry out arbitrage financing in the interest rate market, and use currency basis swaps, which also constitute a large demand for US dollars. Because the cooperation of several tools is required in the foreign exchange market, the demand for U.S. dollars has increased.
As long as the total transaction volume in the foreign exchange market increases, the use of US dollars will definitely increase, and the demand for US dollars will also increase. Because the US dollar accounts for nearly 90% of all foreign exchange transactions, as long as the total amount expands, the transaction volume of the US dollar will be greater, which means that the demand for the US dollar is rising.
>> Third demand
The third demand for dollars comes from the risk hedging of foreign exchange assets of financial institutions.
For example, the retirement funds of Japanese insurance companies hold 1.6 trillion U.S. dollars in assets. These assets need to be hedged. How to hedge? The way is interesting. Japanese insurance company pension funds, through currency basis swaps, exchange the US dollars in their hands for Japanese yen, and then invest in Japanese government bonds. We know that the yield of Japanese government bonds is very low, sometimes negative, and most of the time close to 0. Basically no investment value.
But when they invest in Japanese government bonds, they exchange the U.S. dollar for the Japanese yen through a currency basis swap, and the negative basis of the Japanese yen has brought them huge returns. That is to say, if the dollar is exchanged for the yen, the counterparty of the yen party needs to pay him a negative basis, which is very high. Then, with a negative basis plus a little yield on Treasuries, the overall yield can be very high.
The yield of the yellow line in the above picture can even reach 3%, exceeding the yield of U.S. Treasury bonds. This is a very novel way of playing.
Many countries have negative bond yields, but why would anyone buy them? What they bought was not the yield on these bonds, they bought the negative basis. Around the U.S. dollar, perform currency swaps in the market, get a negative basis, and invest in German, British or Japanese bonds. The bonds themselves may not make money or earn very little, but the basis can bring great profits.
But the problem now is that Japan's long-term ultra-low interest rates have oppressed these insurance companies, and they have nowhere to invest. In addition to the above-mentioned opportunities, these Japanese financial institutions are forced to expand overseas on a large scale. By the end of 2019, the total amount of foreign exchange loans and foreign bond holdings of the Japanese banking system was as high as 4.6 trillion US dollars, the undisputed leader in the world, 30% higher than the second place, the United Kingdom.
Large-scale allocation of overseas assets requires Japanese financial institutions to conduct a series of currency swaps. For example, Japanese investors (financial institutions, insurance companies) want to invest in Chinese bonds and have a lot of yen in their hands, but they cannot exchange yen directly for RMB, because there is not such a large transaction volume, so Japanese insurance companies must First exchange the yen in your hand for US dollars, do swaps, or swaps; then exchange US dollars for RMB, and do swaps or swaps. Renminbi invests in China's bond market to obtain high returns while locking in exchange rate risks. After all, after making money, it has to be exchanged into Japanese yen.
So whether Japanese financial institutions invest in Japanese yen or US dollars, they need large-scale hedging. The Bank of Japan has made a calculation. Based on a 60% hedging ratio, the Japanese financial system holds 4.6 trillion U.S. dollars in assets, and it needs to obtain 920 billion U.S. dollars in capital rolling every month.
This shows that the more foreign currency assets you have, the more you need dollars.
The interest rate difference between Japan and the United States forces Japanese funds to leave, so it will bring about a substantial increase in Japan's demand for US dollar hedging risk hedging.
The yellow line (IOER) in the figure below represents the difference between the Japanese interest rate and the US interest rate (the two are subtracted). Blue lines are insurance companies; gray lines are securities and trust companies; orange lines are depository companies.
When Japan began to implement negative interest rates and the interest rate gap with the United States gradually widened, it was very obvious that these companies' funds left. As long as the funds of Japanese companies leave, they will be converted into US dollars first, increasing Japan's demand for US dollars.
That is to say, the larger the scale of US dollar assets, the greater the demand for US dollars. Japan is the most obvious example.
Let's look at the picture below (the first on the left), which is a picture of the Bank of Japan. The vertical axis represents the currency basis (the negative number represents the degree of scarcity of the US dollar), and the horizontal axis represents the net financial assets of a country.
If it is on the right side of the horizontal axis, it means that the country is a net creditor country, which means that the country lends to the whole world. It can be clearly seen that Japan is a net creditor country, and it is far ahead, lending out more than 3 trillion US dollars. At its worst, the currency basis was as negative as 50 basis points.
A country with a large amount of foreign exchange reserves and a large amount of foreign creditor's rights is actually short of U.S. dollars, which may be second only to South Korea. Why does this phenomenon occur? As I just said, the greater the US dollar net assets, the more US dollars are needed, and then the US dollars are exchanged for local currency. After making money, they are exchanged back to US dollars, and finally exchanged for the destination currency. During the period, several foreign exchange swaps are required to hedge the return risk, which will increase the demand for US dollars.
Therefore, the greater the US dollar net assets of a country, the greater the foreign investment, and the greater the shortage of US dollars.
The picture above (first from the right) is a statistical chart of net foreign exchange assets and currency basis within the banking system around the world. The vertical axis also represents the currency basis (negative numbers represent the degree of scarcity of the dollar), and the horizontal axis represents the net assets of the banking system.
It can be seen that Japan is facing the same problem. The bank's net assets are more than 1 trillion US dollars (net worth, assets minus liabilities), but the currency swap basis is still negative.
If you don't think through this issue, you won't know that the more dollars a country has, the more it needs dollars.
In the same way, the world’s dollar output is increasing, and the scale of asset valuation in the world is increasing. The world will be inseparable from the dollar, until the entire system collapses together, and then the monetary system can be rebuilt. No country can stand alone.
That's why Japan relies heavily on the Fed's currency swaps. The figure below (left one) shows the dollar assets owned by non-US banking systems around the world. Who has the most? Japan has the most, as high as 3 trillion US dollars, which is simply a thriving.
Look at the picture above (first from the right). This picture shows the scale of currency swaps between the Federal Reserve and major central banks after the financial turmoil in March 2020. Who wants the most dollars? Bank of Japan. The Bank of Japan lacked a lot of dollar liquidity from March until August.
This shows that the BOJ still relies heavily on the currency swaps given to it by the Fed. If the Fed doesn't give it, there will be problems in Japan's system. The reason why Japan still occupies the vast majority of the currency swap scale of the Federal Reserve until today is because the Japanese banking system relies heavily on the US dollar, and they cannot find enough US dollars in the market, so they can only rely on the central bank swap provided by the Federal Reserve. This is a very important point in understanding the foreign exchange market.
In fact, when it comes to this, we can understand a problem from the side. That is, many people feel that the Federal Reserve prints money, and the world's dollars are flooded. Don't worry, no, as long as the money dares to flow into the market, Japan will take the lead. Under the printing of money, the dollar may depreciate, but it will never flood. Moreover, there are shadow currencies to check and balance.
>> CIP failure
After talking about the dollar shortage, let's go back to the problem of CIP failure. In fact, this means that the synergy of the dollar circulation is declining.
The difference in yields in different regions produces arbitrage behavior, which drives the dollar circulation, and the dollar circulation mobilizes the allocation of world economic resources to high-yield regions, thereby stimulating the global division of labor, and the global division of labor has brought about strong synergy among the world's economic systems.
Before the financial crisis in 2008, the synergy of the US dollar circulation was very strong, because it could effectively control and dominate the monetary policies of various countries and align with the US dollar. For example, when the U.S. dollar raises interest rates, the central banks of various countries raise interest rates one after another, and when the U.S. dollar lowers interest rates, the central banks of various countries follow up one after another. That is, the central banks of all countries follow the U.S. dollar.
Because if the trend of interest rates is the same and capital is flowing freely, then the exchange rate cannot become bigger and bigger (according to the CIP principle). Even if there is a deviation in arbitrage funds, it can be corrected quickly, which shows that the synergy of the US dollar is very strong.
After 2008, there were signs of a reversal in globalization, and the European debt crisis exposed a bottleneck in the division of labor within the euro zone. For example, in southern Europe and northern Europe, eastern Europe and western Europe, peripheral countries and core countries have become more and more bottlenecks in the division of labor.
As for Japan, the long-term deflationary pressure shows that the economic vitality of Japan's aging society is very insufficient; while China is forced to turn to domestic demand, so it can be seen that in the middle of China's GDP ratio, the proportion of foreign trade is getting lower and lower, and the domestic demand market is getting more and more. come higher.
These all confirm that the demand in the world market is sluggish. It is precisely because various regions have begun to turn inward, regardless of the Fed, and since then the monetary policies of various countries have begun to diverge.
This situation became more obvious after 2014, when the circulation of the US dollar reversed, the US dollar entered into interest rate hikes and shrinking balance sheets, while the currencies of various countries did not follow the pace of the Fed. The euro and the yen are engaging in negative interest rates; China is keeping its currency moderately loose for the domestic market.
Europe, the United States, Japan, and China, the interest rate policies of several major monetary powers have parted ways, and this will inevitably lead to the expansion of exchange rate differences. It is still determined by CIP. As long as the interest rate is different, the exchange rate trend will definitely be different.
As for the central currency of the foreign exchange market, the dollar, the supply is getting tighter and the demand is expanding, making the dollar more and more scarce. Arbitrage funds have no way to bridge the deviation of the CIP. Therefore, the long-term failure of the CIP means that the circulation of the dollar has a negative impact on the synergy of the world economy. Weakening day by day, indirectly proves the fact that globalization has reversed.
In 2020, the new crown epidemic and the financial turmoil forced the Federal Reserve to readjust its policy, and the reduction of the balance sheet to raise interest rates has turned into the expansion of the balance sheet and the reduction of interest rates. Increased tolerance for inflation and preparations for long-term zero interest rates. The United States has to follow the monetary policies of other countries, and everyone can relax. Then restart the dollar hot flow under this situation.
However, in this case, when the thermal circulation of the dollar is started, the surface phenomenon is that CIP is gradually returning, but this does not mean that the synergy of the dollar circulation is recovering and globalization is restarting.
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