Andrew Hunt and Ben Ashby
14 Mar 2022
Accessing dollars outside the U.S. is not as easy as it sounds.
Original article published in NIKKEI Asia: https://asia.nikkei.com/Opinion/Japan-s-banks-suddenly-hold-huge-leverage-over-China-s-economy
Ben Ashby is a former managing director in JPMorgan's Chief Investment Office and current Managing Partner at Good Governance Capital.
As Russia is painfully discovering, the world's financial system is controlled by the Group of Seven economies. With the U.S. Federal Reserve starting to tighten monetary policy as the financial contagion from the Ukraine crisis also starts to spread, dollar liquidity in Asia is likely to become tighter.
Here the vital but little understood function of Japan's megabanks in financing Asia's economy will be a critical factor in ensuring that dollars continue to flow freely in the region.
Despite the growth of China's banking system, much of it remains domestically focused. China's banks also lack the creditworthiness and international connections that Japan's financial institutions enjoy.
With the financing of much of Asia's trade and the flows in and out of its various financial centers still heavily dependent on Japan, Japan's bankers, squeezed between an overheating U.S. and an increasingly troubled China, have a difficult balancing act to perform.
Since the 1990s, Japan's big banks have had a very large and growing deposit base but limited domestic demand for credit, forcing them to look overseas for profits in international capital markets, which are dominated by dollars.
To grow overseas, Japanese banks needed vast amounts of dollars. Fortunately, there was a solution in the Eurodollar market, and this is where things get more complicated.
Simply put, Eurodollars refer to the market for dollars outside of the U.S., which operate quite differently to America's onshore dollar market. Almost a synthetic version of the real thing, Eurodollars can and often do behave differently at times of stress.
The reason is, as Russia is learning to its cost, that most national currencies like dollars and related assets, such as U.S. Treasury bonds, never actually leave the U.S. Even China's vast holdings of more than $1 trillion of U.S. Treasurys ultimately exist as electronic ledger entries in the U.S. financial system and can be frozen at the press of a button.
Using dollars outside America requires a complicated system of interbank loans, where what is used and traded are claims on dollars that remain in the U.S. system rather than actual, let alone physical, dollars themselves.
The first step of this chain often starts in London. Bankers in Tokyo will pledge yen as security for loans and receive Eurodollars in return, enabling them to make loans or buy assets in dollars. In turn, Japanese banks will usually demand some sort of security or collateral for these loans. This can vary from U.S. securities to real estate to the commodities that underlie trade finance.
Because borrowing in Eurodollars is more expensive than borrowing onshore in America, Japanese banks must find higher-yielding returns to offset this cost. This naturally forces them toward higher-risk lending. A good example of this is the failure of Archegos Capital Management, a family office that managed the personal assets of South Korean-born U.S. investor Bill Hwang, which caused outsized losses for Japanese banks.
Another cost relates to complexity and with it, most importantly, fragility. At every stage, there are moving parts such as the value of the collateral backing the loans or the creditworthiness of the banks involved. If all parts of this chain remain stable, then all is well. But sudden changes can cause things to quickly fall apart and dollar liquidity to evaporate. Witness the problems China Construction Bank is having finding dollars to pay for a nickel financing.
What is happening to the Russian financial system now is an even more extreme form of this. Russia's banks, domestic assets and overseas holdings have been largely removed from the system. Without access to hard currency, Russia will be unable to pay for a range of critical imports ranging from medical supplies to aircraft parts.
An information board displays dollar to ruble exchange rates in St. Petersburg on Mar. 8: Russia will be unable to pay for a range of critical imports. © Sipa/AP
There are several less extreme examples of this over the past decade, most recently during the early stages of the COVID crisis in 2020 when Japan's banks suddenly found themselves needing to borrow around $230 billion dollars as funding markets dried up and clients needed emergency loans.
Fortunately, if markets get tough, Japan does have an insurance policy: as a close ally of the U.S., the Bank of Japan can borrow dollars directly from the Federal Reserve to provide a temporary overdraft to its banks.
This is an advantage not available to the People's Bank of China or even the Hong Kong Monetary Authority, which must rely on a finite amount of U.S. currency reserves. Again, as Russia is discovering, the ability to access these reserves depends on the goodwill of G-7 nations.
With the Fed now worried about inflation, likely to lead to a tightening of global liquidity, Japanese banks must now make some tough decisions over what to do with the more than $5 trillion worth of overseas claims they have amassed.
Do they cut back on risk and reduce their Eurodollar borrowing, charge a higher interest rate to borrowers, or become more selective in their lending? Our guess is that they will do a mixture of all three.
With $166 billion of direct exposure to mainland China and Hong Kong, and with huge problems beginning to surface in Chinese real estate, this sector will be a prime candidate for risk reduction. It will be a difficult balancing act and, if Tokyo's bankers do not pull it off, it may add to China's own problems at an already difficult time.
One of the lessons we can take from the tragic Ukraine crisis is that, until China's financial system matures, Asia's most important bankers remain in Tokyo.