Should-Read: Izabella Kaminska: Global Trade Alert

Should-Read: And how would the adverse Hayekian business shock manifest itself if not in a sharp slowdown in the growth of trans-Pacific trade? Very interesting. But I don’t now what or how to think about this yet:

Izabella Kaminska: Global Trade Alert: “Hyun Song Shin’s latest thoughts on the connection between the bank/capital markets nexus, the dollar shortage problem and the break down of covered interest rate parity arbitrage deserve some careful consideration…

…Shin reminded the audience that every argument which suggests market finance is a stabilising influence on the financial system (acting as a spare tire when the banking sector is impaired) can be offset with the argument that capital markets force banks to behave even more pro-cyclically than they might otherwise be inclined to do so….

When banks and other financial intermediaries are stretched to high levels of leverage, supported by razor-thin haircuts, any slight knock to the haircut leaves them vulnerable to forced deleveraging… [which] is the key to understanding funding pressures on banks….

The Vix no longer works as a barometer of leverage appetite…. This poses a bit of a conundrum:

On one hand, there are signs of unabated risk appetite in financial markets, as witnessed in high stock market valuations, compressed credit spreads and subdued volatility, the recent pickup notwithstanding. Yet the banking sector is going through a tough time. In contrast to the overall stock market, banking stocks are struggling, with depressed market-to-book ratios, especially for advanced economy banks outside the United States. Why is this?
Bear with us, because the answer is quite disturbing.

As Shin notes, the easy answer is the weirdness of extended monetary easing…. The more complex answer is that it’s all down to overly restrictive bank regulation…. Introduce the breakdown of covered interest rate parity (CIP) into the equation (because yes, according to Shin it’s all connected), and we find ourselves in an exceptional situation…. He proposes the gap may be persisting because banks simply do not have enough capital available to take on such transactions. Indeed, given many banks have capital comfortably above any regulatory constraints…. So what’s the real issue?

As interest rates have fallen to historically low and even to negative levels in some regions, investors searching for yield have sought higher-yielding assets. In practice, given the global role of the dollar as the borrowing currency of choice, such higher-yielding assets have been denominated in US dollars, even if the borrowers are non-US residents. Long-term yields for US dollar-denominated securities have been higher than for assets of similar maturities in Japan, the euro area or Switzerland. For institutional investors who hold a global portfolio of assets, the currency mismatch between the assets they hold and the commitments they have to their domestic stakeholders in yen, euros or Swiss francs looms large….

Follow the implications of the stronger dollar for the viability of lengthy global value chains (GVCs). Long production chains make heavy demands on working capital…. The financing demand typically grows at the rate of the square of the length of the chain…. The strength of the dollar tracks closely the latest slowdown in export growth. Could it be that the tighter financial conditions resulting from the stronger dollar have been a drag on export growth?… This is an issue of first-order importance…