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The dollar as barometer for credit market risk

The external value of the USD has become a key factor of U.S. and global credit conditions. This reflects the surge in global USD-denominated debt in conjunction with the growing importance of mutual funds as the ultimate source of loan financing. There is empirical evidence that USD strength has been correlated with credit tightening by U.S. banks. There is also evidence that this tightening arises from deteriorating secondary market conditions for U.S. corporate loans, which, in turn, are related to outflows of credit funds after USD appreciation. The outflows are a rational response to the negative balance sheet effect of a strong dollar on EM corporates in particular. One upshot is that the dollar exchange rate has become an important early indicator for credit market conditions.

Niepmann, Friederike and Tim Schmidt-Eisenlohr (2018), “Global Investors, the Dollar, and U.S. Credit Conditions”, CESifo Working Papers, 7288.

The post ties in with SRSV’s summary lecture on asset management and with the summary lecture on macro trends.
The below summary consists of quotes from the paper. Emphasis and cursive text have been added.  

Evidence of correlation of USD exchange rate and lending conditions

“Commercial and industrial loans (C&I) are an important source of credit for U.S. corporates. C&I loans on the balance sheet of U.S. banks stood at more than $2.1 trillion at the end of 2017. That said, the total volume of these loans is significantly bigger because banks sell a large portion of the loans they originate, especially the riskier ones, on the secondary market to institutional investors within 30 days of origination.”

Appreciation of the U.S. dollar is associated with a reduction in the supply of commercial and industrial loans by U.S. banks…The…correlation [is] illustrated in [the figure below]. The solid line shows the log difference of the value of corporate loan originations for 16 major U.S. banks at a quarterly frequency. The dashed line depicts the quarterly change in the broad dollar index, a trade-weighted index that includes the bilateral dollar exchange rates of major U.S. trading partners. A clear relationship is apparent: When the dollar appreciates, U.S. banks reduce lending and vice versa. A one-standard deviation rise in the index (equivalent to an increase of 2.5 points) leads to a 10% reduction of new loan originations.”

“The effect of the dollar on loan originations is little changed when the control variables [that account for other linkages between the dollar exchange rate and credit conditions] are included, [such as] the change in the log of the CBOE Volatility Index (VIX)… the spread between the 10-year and 3-month treasury rate as well as the change in the effective federal funds rate.”

“Detailed information on banks’ internal risk ratings of loans reveals that banks not only lend less but also shift to safer borrowers when the dollar appreciates. The same picture emerges from an analysis of credit standards. Based on data from the Senior Loan Officer Opinion Survey, an appreciation of the dollar is associated with a tightening of credit standards for C&I loans by U.S. banks.”

The reason for the correlation of USD exchange rate and lending conditions

“As global investors have become more involved in traditional financial intermediation in the United States, they are changing macro-financial linkages…The increased importance of institutional investors as a funding source for C&I loans has led to the emergence of a new macro-financial channel that we term the secondary market channel…The size of the syndicated loan market, which captures the majority of loans that are originated and then sold, has increased tremendously since the 1990s, and so has the role of institutional investors as buyers of these loans.”

“Because these investors are sensitive to global developments, and, in particular, to dollar movements, credit conditions for U.S. corporates are affected by the dollar exchange rate: When the dollar appreciates, institutional investors reduce their demand for loans on the secondary market. As a consequence, U.S. banks tighten credit standards and originate fewer C&I loans…

  • The Senior Loan Officer Opinion Survey asks banks for their reasons for tightening or easing credit standards…The single reason that is significantly associated with dollar movements is “changes in the liquidity in the secondary market for these loans”…
  • Results of bank-level regressions…include the interaction term that tests whether banks’ sensitivities to the dollar depend on the extent to which they sell off loans. The interaction term is significant at the 1% level, indicating that loan originations of banks that pass on more loans to outside investors are more responsive to dollar movements, entirely consistent with the role of the secondary market.”

“A stronger dollar weighs negatively on U.S. economic activity through the secondary market channel, which is distinct from traditional channels linked to the terms of trade or monetary policy.”

Results are mainly driven by the emerging markets dollar index, especially after the global financial crisis…When emerging market currencies depreciate vis-a-vis the dollar, bank loan funds experience outflows, prices and liquidity on the secondary market fall, and U.S. banks tighten credit standards.”

Evidence of correlation of USD exchange rate and secondary loan market conditions

“[As the dollar appreciates] prices and liquidity fall in the secondary market…A one-standard-deviation increase in the dollar decreases the leveraged loan index by 0.4 percentage points… Because we know that banks are originating fewer loans and tighten loan standards when the dollar appreciates, we can interpret the negative effect of the dollar on prices as driven by demand: Non-bank investors, the main buyers on the secondary market, buy fewer loans when the dollar appreciates.”

Effects are stronger for riskier loans… For risky loans… if the average price of the loan is 97%…the price effect of a one-standard-deviation increase in the dollar is -0.7%-points compared with an effect of -0.04%-points for the less risky category.”

“According to the estimates, the correlation between the dollar and secondary market prices (bid-ask spreads) becomes negative when the share of U.S. banks drops below 26%, which happened for the first time around 2001.”

The reason for the correlation of USD exchange rate and secondary loan market conditions

“Today, the main buyers of U.S. corporate loans—and, hence, suppliers of funding for these loans—are institutional investors, in particular mutual funds, which experience outflows when the dollar appreciates.”

“When the dollar appreciates, funds specialized in U.S. bank loans experience outflows, as investors pull money out. Faced with these outflows, funds then need to reduce their holdings of U.S. corporate bank loans, which leads to a fall in the demand for these loans on the secondary market…Effects are material. A one-standard-deviation (monthly) appreciation of the dollar implies an outflow of 0.77 percent of assets under management… A one-standard-deviation rise in the dollar then leads to outflows of around $3.2 billion. Given that mutual funds make up around 30% of the secondary market, this effect would scale to about $8.5 billion if all other non-bank buyers in the secondary market reacted similarly to the dollar.”

“[The figure below] presents graphical evidence, documenting a clear negative correlation between fund inflows and the broad dollar index.”

Global investors are sensitive to the dollar because of their large exposures to dollar-denominated emerging market corporate debt… When the dollar appreciates, this debt becomes riskier and investors might want to reduce their exposures.”

“The dollar can be understood as a ‘barometer’ of the risk-taking capacity in global capital markets, where global investors move to safer assets when the dollar appreciates. This risk factor is not reflected in any other proxy of risk sentiment …the dollar appears to be a global risk factor that is not primarily linked to developments in the United States and the risk-bearing capacity of U.S. banks, but associated with global investors’ risk attitudes, which respond also to foreign developments.”


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