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The currencies that have experienced the largest change from a negative basis in mid-March to a positive basis in early April include the Japanese yen, the Mexican peso, the Swiss franc, the Danish krone, and the euro. The cutoff date for the analysis in this note is April 30, 2020.
The three-month Mexican peso basis was positive early in the global financial crisis and turned negative only in the second half of 2009; it remained mostly negative thereafter. See Bush (2019) for more details.
As shown in the October 2019 GFSR, an increase in the VIX is likely to reduce demand for risky investments denominated in US dollars, thereby alleviating pressure on the cross-currency basis. This is because the estimated model controls for domestic risk in home economies through a measure of implied foreign exchange volatility so that the VIX captures the riskiness of dollar-denominated assets.
The October 2019 GFSR shows that the cross-currency funding ratio amplifies the effect of other drivers on the cross-currency basis. Thus, for the same increase in a given driver, a country with a larger cross-currency funding ratio tends to experience larger widening of the cross-currency basis. However, due to data limitations, the cross-currency funding ratio can be computed only up to the third quarter of 2019 for some currencies, the first quarter of 2018 for others.
Predictions are generated for currencies for which data are available for all relevant variables in the baseline model.
The Infectious Disease Equity Market Volatility Index, developed by Baker, Bloom, Davis, and Terry (2020), combines three indicators: stock market volatility, newspaper-based economic uncertainty, and newspaper-based tracking of infectious-disease-related words to capture real-time forward-looking uncertainty related to the spread of infectious diseases.
Additional specifications of the model were estimated that included nonlinear terms for the VIX, as well as its interaction with variables such as the cross-currency funding ratio. These augmentations helped improve the fit of the model and lower the forecast error for a majority of currencies.
Chui, Kuruk, and Turner (2016), for example, provide evidence that foreign currency liabilities of emerging market firms are likely not fully hedged by foreign currency revenue or foreign exchange derivatives. Bruno and Shin (2017, 2020) show evidence on emerging market nonfinancial firms’ tendency to engage in US dollar carry trade and how such activity combined with their building of cash balances may make them more vulnerable to a stronger US dollar.
The initial pricing to access the facility was the three-month OIS rate plus 200 basis points, whereas the three-month financial, nonfinancial, and asset-backed commercial paper three-month rates were well below the OIS rate plus 200 basis points at the time of the policy announcement.
To increase the swap lines’ effectiveness, the foreign central banks with standing US dollar liquidity operations also agreed to begin offering US dollars weekly in each jurisdiction, with 84-day maturity, in addition to one-week-maturity operations already in place. The changes took effect during the week of March 16, 2020.
These results are consistent with those obtained by Cetorelli, Goldberg, and Ravazzolo (2020), who undertook event studies on the effects of policy announcements of the Federal Reserve swap line on the cross-currency basis within a two-day window.
It should be noted that around the time of the swap line announcements, other policy actions were taken both by the Federal Reserve and on the fiscal front, which may have helped improve investor risk sentiment and may have had an impact on US dollar funding conditions. In particular, on March 31, the Federal Reserve also announced the establishment of a temporary repurchase agreement facility for foreign central banks and other international monetary authorities (FIMA Repo Facility), which allows foreign and international monetary authority (FIMA) account holders to enter into repurchase agreements with the Federal Reserve to temporarily exchange their US Treasury securities held with the Federal Reserve for US dollars. The facility became effective April 6, 2020, but information on individual repurchases by the FIMA account holders is not publicly available for a meaningful analysis of its impact.
The effects of the swap line announcement are difficult to separate from those of Federal Reserve policies providing liquidity to the market around that time, but this result holds if other factors, such as the bid-ask spread, the US dollar index, and the VIX, are included in the model economies is also manifested in a tightening of domestic financial conditions, which turns out to be positively correlated with widening of the cross-currency basis (Figure 8, panel 3).
Complementing syndicated loan data with fund portfolio flows data, the analysis shows that the sharp decline in bond and equity flows to emerging markets during the first quarter of 2020 is also associated with the widening of the cross-currency basis in lending economies.