Economics in central banking: Wenxin Du

The past few years have delivered many stark illustrations of the US dollar’s centrality in global financial markets. The shock to dollar funding markets in March 2020 triggered a worldwide flight to safety that became known as the ‘dash for cash’, which was only halted by unprecedented interventions by the Federal Reserve. Two years on, when Russia launched its invasion of Ukraine, investors nervously eyed the cross-currency basis for signs that trouble might be flaring up again.

So far in 2022, brief surges in the basis have not led to major dislocations. But the fact that investors reached for what was once a little-known and broadly uninteresting financial indicator is a mark of two key developments. One is a seismic shift in the operation of global markets since the 2008 financial crisis. Another is the ground-breaking work of Wenxin Du, one of a handful of economists whose research has shed light on the changed system in which the world is now living.

Du is a financial economist leader at the Federal Reserve Bank of New York and associate professor of finance at the University of Chicago Booth School of Business. Her work in recent years has explored deviations from covered interest parity (CIP), a textbook relationship that says banks should arbitrage away any difference between the dollar interest rate in the cash market and the implied rate in foreign exchange markets. The cross-currency basis measures this difference, and it should be zero if CIP holds. Since the advent of the Basel III capital accord, however, the basis has tended to be slightly negative, implying the synthetic dollar interest rate in the FX swaps market is higher than the cash rate.

“The cross-currency basis has emerged from an esoteric corner of the FX derivative market to become an important barometer of the health of global capital markets,” wrote Du with Jesse Schreger – himself a past recipient of Central Banking’s economics award – in a working paper published in 2021.

The basic issue, as Du’s work shows, is that banks are now constrained by the Basel III leverage ratio, which sets a capital requirement for all exposures, including supposedly risk-free arbitrage of the cross-currency basis. This has created a “balance sheet cost” to arbitrage, and has led to persistent deviations from CIP.

The finding has major implications. Deviations from CIP can mean large differences in funding costs around the world, for both sovereigns and banks that do not have direct access to the dollar cash market. The fact that deviations from CIP become larger during periods of stress implies that global banks with access to dollar cash do not necessarily pass it on to less fortunate counterparties. The reluctance by global banks to supply dollar liquidity necessitated the Fed’s radical actions in March 2020, including reopening swap lines to several other central banks, launching a vast quantitative easing programme, and – crucially – loosening the leverage ratio constraint.

“My personal view is we can handle small, stable deviations from CIP,” Du tells Central Banking. “However, we cannot guarantee a small and stable deviation. The deviation can get quite large and volatile at precisely the worst time.”

Du has reminded us how risk-taking and leverage are essential ingredients in our understanding of international finance and the transmission channels of monetary policy

Hyun Song Shin, Bank for International Settlements

A trio of papers Du issued as preprints in 2021 help trace out the implications of the dollar’s role. The working paper with Schreger – forthcoming as a chapter of the Handbook of International Economics – tells the story so far of CIP deviations and the implications for global financial markets.

One issue the paper raises is the need for a better model of the welfare implications of CIP deviations. “The issue is much more important than simply deadweight losses, because it really affects the long-run prospects of the dollar as the global reserve currency, and issuance patterns of dollar-denominated securities,” says Du.

But building a model is not straightforward. “We do face significant data gaps in these markets,” she adds. “In ongoing work with the European Central Bank, we are taking a granular look at the transaction level for FX swaps to see who is willing to pay more, whose demand is more inelastic.”

A second paper with Schreger, accepted for publication in The Review of Financial Studies, shows how the private sector’s foreign currency debt raises the risk of sovereign default, even as sovereigns have cut their own reliance on dollar borrowing.

A third paper, co-written with Benjamin Hébert and Amy Huber, goes beyond the existing literature on CIP deviations to explore the constraints that led to the current state of affairs. Derivatives pricing suggests that the risk of the constraints becoming tighter is priced. The authors conclude the finding is “strongly supportive” of intermediary asset pricing theory, which states that large CIP deviations are a sign that institutions are constrained.

“More broadly, we view this paper as beginning an investigation in the dynamics and pricing of arbitrages induced by regulatory constraints,” the authors say. “If intermediaries play a central role in both asset pricing and the broader economy, then the question of how to measure the constraints they face and the properties of those constraints is of first-order importance.”

Hyun Song Shin, head of research at the Bank for International Settlements, says Du’s work has been “hugely influential” in policy circles and academia.

“She has trained a spotlight on the role of financial intermediation in funding and FX markets, and has reminded us how risk-taking and leverage are essential ingredients in our understanding of international finance and the transmission channels of monetary policy,” says Shin, who has collaborated with Du in the past.

Du is now exploring several further research avenues. One is the role of non-banks in driving dislocations in dollar markets. “A fascinating topic in this low-yield environment is how do institutional investors actually decide where to invest in terms of the destination country and the currency,” she says.

Another key area is the functioning of the Treasury market, which became impaired during the March 2020 crisis. “In my view, a lot of these frictions, a lot of these bottlenecks and issues with the FX swaps and with repo markets also feed into the functioning of the Treasury market,” says Du.

The role of non-bank financial intermediation and the structure of the Treasury market are now top priorities for regulators in the US and worldwide. Du’s work looks set to continue influencing the policy debate in the years to come.

The Central Banking Awards were written by Christopher Jeffery, Daniel Hinge, Dan Hardie, Victor Mendez-Barreira, Ben Margulies and Riley Steward