What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia?

Gee Hee Hong, Anne Oeking, Kenneth H. Kang and Changyong Rhee
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Gee Hee Hong: International Monetary Fund
Kenneth H. Kang: International Monetary Fund
Changyong Rhee: International Monetary Fund

Open Economies Review, 2021, vol. 32, issue 2, No 6, 394 pages

Abstract: Abstract Asian countries have high demand for US dollars and are sensitive to US dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow US dollars or other currencies on a hedged basis via the cross-currency swap markets. These deviations can be explained by regulatory changes since the GFC, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of US dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while eases financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market, or stable long-term investors, including a “hedging counterpart of last resort,” can help stabilize financial intermediation when US dollar funding markets come under stress.

Keywords: Covered interest parity; Limits to arbitrage; US dollar funding; FX swaps (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1007/s11079-020-09594-3

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