The Journal of Finance | Macro Paper Warehouse

Deviations from Covered Interest Rate Parity

Covered interest rate parity is the no-arbitrage relation that pins the forward exchange rate to the spot rate and the interest differential; the paper’s own description is that it is “presented in all economics and finance textbooks and taught in every class in international finance.” This paper documents that it is systematically and persistently violated among G10 currencies after the 2008 crisis, establishes that the violations are genuine arbitrage rather than compensation for credit risk or transaction costs, and traces them to the cost of using a bank balance sheet. (The magnitudes cited here come from the February 2017 NBER working-paper version, the freely available full text this summary rests on; the published version appeared in the Journal of Finance in 2018.) The scale of the market matters for how surprising this is: $61 trillion notional outstanding and $3 trillion average daily turnover. Over 2010-2016 the average annualised absolute Libor cross-currency basis is 24 basis points at three months and 27 basis points at five years, but those averages conceal a lot – the five-year yen basis was close to -90 basis points at the end of 2015, larger in magnitude than the roughly -70 basis point five-year Libor differential between Japan and the United States. Two moves rule out the standard explanations. The credit-risk story, that interbank panels differ in creditworthiness, is tested directly on panel banks’ CDS spreads and finds little support; more decisively, the authors recompute the basis on instruments with no credit-risk difference at all – general collateral repos, which are fully collateralised, and Kreditanstalt für Wiederaufbau bonds, fully backed by the German government – and the basis survives. The repo basis is persistently and significantly negative for the yen, Swiss franc and Danish krone, ranging from -16 basis points for the euro to -36 for the Danish krone, and the KfW basis is significantly non-zero for the euro, Swiss franc and yen (about -14, -24 and -30 basis points) while being effectively zero for the Australian dollar. Net of measured transaction costs, the resulting arbitrage profits run from 9 to 20 basis points annualised, with standard deviations of 5 to 23 basis points – small numbers, but with zero conditional volatility over the fixed investment horizon, so the Sharpe ratios are infinite. On explanation, the paper advances a two-factor hypothesis: costly post-crisis financial intermediation, which explains why the deviations are not arbitraged away, plus persistent international imbalances in funding supply and investment demand across currencies, which explains why the basis lines up with the level of nominal rates. Four empirical characteristics follow. First, the deviations spike at quarter ends, and the timing is sharp in a way that identifies the mechanism: the one-month deviation jumps exactly one month before quarter end, the one-week deviation exactly one week before, while a three-month contract – which appears on a quarter-end report whenever it is executed – shows no such pattern. Second, using the Fed’s interest on excess reserves in place of Libor/OIS/repo as the direct dollar funding cost, as a proxy for the shadow cost of leverage, explains about one-third of the one-week deviations; also investing at foreign central banks’ deposit facilities shrinks the average basis from -26 (Libor) and -28 (OIS) basis points to -8, which the conclusion describes as accounting for two-thirds of the deviations – while still leaving -12 to -15 basis points for the krone, franc and yen. Third, the basis is positively correlated with the level of nominal interest rates, with a 89 percent correlation between five-year Libor bases and five-year Libor rates across G10 currencies, so the hedged arbitrage trade is long low-rate and short high-rate currencies – exactly the reverse of the unhedged carry trade. Fourth, the basis co-moves with other near-risk-free fixed-income spreads, notably the KfW-over-bund basis and the US Libor tenor basis. The authors are careful about what they have and have not shown: they present “the first international evidence on the causal impact of recent banking regulation on asset prices,” but state that assessing the welfare cost “is behind the scope of this paper; it would necessitate a general equilibrium model.”

Local Currency Sovereign Risk

Sovereigns that borrow in their own currency can always print the money to pay, so a common modeling assumption is that such debt is free of default risk; this paper builds a measure to test that and finds it false. The authors define the local currency credit spread as the yield on a local-currency (LC) government bond minus a synthetic LC risk-free rate assembled from the U.S. Treasury yield plus the long-dated forward premium implied by cross-currency swaps – equivalently, the promised dollar spread a global investor locks in by holding the LC bond with a matched swap, and equivalently the size of the failure of long-term covered interest parity between emerging-market and U.S. government bond yields. Using a new hand-built dataset of daily zero-coupon LC and foreign-currency (FC) yield curves and swap curves for 10 emerging markets from January 2005 to December 2011, at a 5-year benchmark tenor, they find the mean spread of LC nominal yields over U.S. Treasuries is 5 percentage points, of which their decomposition attributes 3.72 points to currency risk and 1.28 points to credit risk. The LC credit spread averages 128 basis points, is positive and statistically significant for every one of the ten countries, and stays significantly positive even after deducting half the bid-ask spread on the swaps to allow for transaction costs (that half-spread averages 19 basis points). It is nonetheless generally lower than the same sovereign’s FC credit spread, which averages 195 basis points – a gap of 67 basis points, widening to 86 basis points once swap transaction costs are netted out – and significantly negative in every country except Brazil, where a financial-transactions tax on foreign fixed-income investment drove the two apart. The two spreads also differ in structure: the first principal component explains only about 53 percent of LC credit spread variation across countries versus over 81 percent for FC spreads, and FC spreads are far more tightly tied to global risk factors (a 93 percent correlation between the first principal component of FC spreads and the VIX, against 76 percent for LC spreads). The ex-ante pattern is mirrored ex post: once currency risk is swapped away, LC bond excess returns carry no significant loading on global equity returns while FC excess returns do, so hedged LC debt is safer than FC debt on this measure despite the reputation of emerging-market local debt. Turning to why the spreads differ, the paper distinguishes differential cash-flow risk, differential liquidity, and differential pass-through of global risk aversion, and shows in panel regressions with country fixed effects that the VIX and bid-ask liquidity measures alone explain 46.7 percent of the within-country variation in the LC-minus-FC spread differential – the large majority of what is explained even after a full set of local and global macroeconomic fundamentals is added. The scope conditions matter: ten countries, a single seven-year window spanning the global financial crisis, a 5-year tenor, and a measure that is model-free about default but silent on which of taxes, convertibility restrictions, selective default, or risk premia drives the level of the spread in any individual country.

The International Bank Lending Channel of Monetary Policy Rates and QE: Credit Supply, Reach-for-Yield, and Real Effects

Using the universe of business loans in Mexico matched to firm and bank balance sheets, this paper shows that each foreign monetary policy moves local credit supply mainly through banks headquartered in that jurisdiction, with real effects on firms’ investment, employment and survival that are stronger for policy rates than for quantitative easing, and with the extra credit flowing disproportionately to borrowers who were already paying high rates and who then default more. The data are the Mexican supervisor’s monthly reports on every new and continuing commercial loan, spanning June 2001 to December 2015, with no minimum loan size, giving 8,268,794 firm-bank-month observations for 169,576 firms and 38 banks, and including loan rates, maturity, collateral and arrears – loan rates being “absent in most credit registers around the world” – merged with firm balance sheets and monthly bank balance sheets. Mexico is chosen because US and European banks’ Mexican subsidiaries account for 58 percent of all commercial bank credit there, so policy shocks exogenous to Mexico can be traced through the lenders they hit; the authors stress the general relevance by noting that foreign banks hold “around 50 percent of the market share in terms of loans, deposits and profits” in emerging and developing countries. Identification stacks firmbank, stateindustryperiod and firmmonth fixed effects, and the coefficients barely move between the last two despite an R-squared rise of about 43 percentage points, which the authors read as evidence that firm fundamentals are strongly exogenous to bank shocks. The headline loan-level estimate is that a one-standard-deviation reduction in foreign policy rates raises foreign banks’ credit volume in Mexico by about 2.1 percent, lengthens maturity by 6.7 percent, raises the probability of default over the next year by 9.8 percent, and raises collateral by 5.7 percent – the last plausibly a valuation effect, with the main results holding when collateral is controlled for. Country by country, a one-standard-deviation cut in the fed funds rate raises US banks’ loan volume by 6 percent against 4.8 and 2 percent for UK and euro-area banks under their own rates, while quantitative easing is weaker and narrower: Fed balance-sheet expansion raises US banks’ volume by 2.6 percent and Bank of England expansion raises volume by 2.1 percent, but euro-area QE “becomes statistically insignificant once we control for time-varying unobservables at the state and industry level.” Transmission is not instantaneous – effects are “generally strongest between 6 and 12 months” and weaken after 12 to 15 months. At the firm level, where bank switching is rare (only 9 percent of firms change their main bank year to year), a one-standard-deviation easing raises total bank credit by 1.5 percent, total liabilities by 1.2 percent, fixed assets by 0.5 percent and employment by 0.3 percent, and cuts firm exit due to loan defaults by 1 percent, while QE has no significant overall real effects. On risk-taking, easing raises high-yield borrowers’ loan volume by 5 percent against 1.3 percent for low-yield firms, lengthens their maturity by 10 percent against a negligible effect, and raises their default rate by 11.7 percent with “no significant impact for low-yield firms,” with a QE expansion raising it by 8.6 percent. The paper’s own summary of the two-sided implication is that core-country policy spills over “both in the foreign monetary softening part (with not only higher credit risk taken by foreign banks, but also higher liquidity risk stemming from higher foreign funding) and in the tightening part (with the negative associated local real effects in terms of lower firm total assets, net investment, employment and survival).” Scope conditions are stated rather than buried: the QE real-effects nulls may reflect low power given few post-QE annual observations, effects are stronger for firms with fewer than 50 employees and “inexistent for large firms” while Orbis over-represents large firms, and QE results are weaker the higher the home sovereign’s CDS.