Figure 1
What is Dollar Liquidity?
Dollar liquidity is defined as the sum of the Federal Reserve’s custody holdings and the U.S. monetary base. The Fed’s custody holdings are liquid dollar assets held for foreign entities trading with the U.S., while the monetary base consists of U.S dollars readily available to deploy into the economy. The creation of dollars in offshore markets is fluid, with the Fed intervening to increase and limit liquidity based on global dollar availability and economic trends. This intervention can be summarised by the below points:
- Hot U.S. Economy :
The U.S. authorities implement macroeconomic policies that lead to dollar strength, including raising interest rates. - High Interest Rates :
These flatten the yield curve, reducing borrowing incentives, shrinking the money supply, and decreasing capital spending, which in turn dampens demand for imports and narrows the current account deficit. - Upward Pressure on Exchange Rate :
The reducing of the current account deficit also leads to a reduced outflow of U.S. dollars abroad putting upward pressure on the exchange rate. - Slowing Economy :
As the economy slows due to high interest rates and a stronger dollar, the Fed adopts more accommodative policies, leading to a weaker dollar. - Foreign Exchange Reserves :
Accumulated FX reserves are reinvested in U.S. Treasurys, financing the budget deficit.
Current State of Dollar Liquidity
Recent data indicates a rapid shrinkage in dollar liquidity (as shown in figure 2):
- U.S. Currency Abroad :
The proportion of U.S. currency held abroad has decreased from 4.4% of GDP in 2020 to 3.7% today, indicating a slowdown in the annual outflow of dollars.
- Offloading U.S. Treasurys :
Major holders like China and Japan are reducing their U.S. Treasury holdings, driven by domestic economic policies and geopolitical factors.
- Fed’s Tapering :
The Fed’s reduction of asset purchases has drained U.S. dollar liquidity, contracting the monetary base and reducing commercial banks’ excess reserves.
- Shift to Hard Assets :
Foreign central banks are increasingly investing in gold and other hard assets, further reducing the amount of USD liquidity abroad.
Figure 2
Future Outlook and Implications
Despite current challenges, the dollar remains the world’s reserve currency, with the Fed acting as the ultimate lender of last resort. Nearly half of global transactions under the SWIFT system and 88% of international transactions are conducted in U.S. dollars, according to the Bank of International Settlements (BIS). This reliance on the USD for trade can have negative impacts during times of constrained liquidity. The more costly it becomes to acquire dollars offshore the more nations will replace capital spending with debt repayment.
Conclusion
The interplay of robust demand for dollars and strategic Fed interventions highlights the critical role of dollar liquidity in global financial stability. The current reduction in dollar liquidity underscores the need for vigilant monitoring of macroeconomic policies and global economic trends. As the Fed navigates these dynamics, its actions will be pivotal in determining the trajectory of the dollar and its impact on global markets.
Reference
- BCA Research – Implications Of Shrinking Dollar Liquidity – 12 July 2024
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