Finance’s Addiction to Dollars Leaves World Vulnerable to U.S.

(Bloomberg) -- The U.S. dollar’s growing dominance in international finance means that American problems can quickly pose a threat to the entire world.

That’s one takeaway from a report by a committee at the Bank for International Settlements, which noted that the greenback’s share as an international funding currency has grown to levels not seen since the early 2000s. Stresses in global funding markets earlier this year as the coronavirus began harming the U.S. economy highlight how easily a dollar-related shock can spread.

“The widespread use of the U.S. dollar has benefited participants, but the resulting interconnectedness of the market can also create vulnerabilities,” said the report released Thursday from the Committee on the Global Financial System. “The structural shifts have increased market complexity as well as the speed and scope of stress transmission throughout the global financial system.”

The growth in greenback funding has been driven largely by market-based financing. Over the past five years, around 75% of the increase in demand has been in the form of debt securities such as bonds, medium-term notes and money market instruments rather than bank lending, the BIS said. Around half of all cross-border bank loans and international debt securities are now denominated in dollars.

The dollar also accounts for 61% of official foreign-exchange reserves and around 85% of all foreign-exchange transactions occur against the greenback, according to the report. About half of international trade is invoiced in the currency.

This dominant role has at least two consequences. First, when entities borrow in dollars, movement in U.S. interest rates, which could result from changes in the U.S. outlook or global risk aversion, can have important impacts on their exposures, in particular if they are unhedged.

Secondly, financial globalization may have led to a more synchronized behavior in the financial system, partly because so many international investors and borrowers are exposed to the U.S. currency.

‘Larger Reactions’

“Greater similarity across portfolios may lead to greater similarity in response to shocks to risk aversion or changes in U.S. interest rates, which can lead to larger reactions overall,” the bank said.

The CGFS also warned of a risk that arises from the increased importance of non-bank institutions borrowing and lending in dollars. If pension funds, insurers or other entities experience distress, it could trigger fire sales that result in volatility that ripples through markets, it said.

The CGFS is one of the committees at Basel, Switzerland-based BIS. Its job is to assist central banks in analyzing and responding to threats to the stability of markets and the global financial system.

The group suggested that better data collection by the official sector, strengthened regulatory treatment of currency mismatches on non-bank intermediaries’ balance sheets, and more robust safety nets can help mitigate risks associated with dollar funding.

©2020 Bloomberg L.P.