Monday, March 9, 2009

Reasoning out how the crisis spread around the world

The BIS paper on the dollar funding shortage doesn’t clearly explain how the crisis was transmitted from the United States to Europe.It’s easier to begin with understanding as to how the American problem was transmitted to different emerging markets. For several years emerging markets around the world had high interest rate regimes and had good growth due to secular strucutural changes in their domestic economies. Banks headquartered in New York,London made out loans denominated in USD to say, banks headquartered in BRIC countries. Rolling over the shorter term lower interest rate USD loans was the source of funding for a number of banks in the BRIC countries, who were able to profit from the interest rate spread across the currencies. Secondly a number of foreign institutional investors held equities in these markets, sometimes more than 20% of the total local market cap. These investments were made by using the integration of i-banking and commercial banking; and used the same source of funding - the New York/London interbank/FX Swap/Central bank dollar funding sources.Once the credit crisis broke loose in the US, the disruptions led to a vary large correction in these exchanges, and a local liquidity crisis due to inability to roll over the USD loans.The BIS paper classifies banks by their headquarters in different European countries. It totals up the “dollar denominated claims” of those banks, and totals up their “local currency assets”. Then it shows that the excess of the dollar denominated claims over the local currency assets was funded through the above three sources of USD funding.There are two important aspects here. A “dollar denominated claim” might perhaps be held in any geography, and not only in the US. This is because banks might lend to say I-Banks that might then go and invest in EUR denominated equities. Or a bank HQ’ed in Germany might make out a dollar-denominated loan to a bank HQ’ed in Eastern Europe; and the Eastern European bank might then lend to the local emerging market in its own currency. And so on.This requires a lot of further analysis and thinking. To be continued…

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