If the US reforms the corporate tax code in the next four years, the dollar’s ongoing surge pricing could get worse, as Credit Suisse macro strategist Zoltan Pozsar observes in his latest note. That’s because corporate earnings held overseas are a significant part of the offshore market for dollars, he says. As a refresher, US companies face global taxation, but their foreign earnings aren’t taxed until they’re brought back onshore. Many US-based multinational companies therefore… simply don’t. If companies are required strongly encouraged to repatriate those profits, that would leave an even smaller pool of dollars available for global banks’ funding needs. Furthermore, even if that doesn’t occur, recent regulatory changes should still prompt the Federal Reserve to perform more dealer-like functions, Pozsar says. He has been saying for months that it’s become more important for the Fed to be a source of liquidity (the “dealer of last resort”) than a source of loans (the “lender of last resort”). From the note, with our emphasis: These offshore cash balances form an integral part of the funding base of Eurodollar loan books across the globe. Were these cash balances to flow back into the US, then even more of the funding of Eurodollar assets would have to come from large American banks through FX swaps. The impact of this … would make money fund reform look like baby stuff. New money-market fund regulations have certainly made a difference for foreign banks that do business in dollars. Izzy has covered some of the destabilising effects of dollar scarcity on trade and globalisation. Those foreign “Yankee banks” don’t have the same cushion of dollar deposits as American banks, and therefore need to manage their currency exposures with swaps and dollar-denominated debt issuance. But the US money-market funds that buy commercial paper from foreign banks – one large source of dollar funding – have shrunk quite a bit because of the new rules. There have been about $800bn of withdrawals from prime money-market funds over the course of a year, according to the Treasury Borrowing Advisory Committee, an industry group that advises the US on debt management. (To compare, Goldman Sachs estimates there’s about ~$1tn of S&P 500 company earnings offshore.) As a result of those prime-fund withdrawals, foreign banks have cut their issuance of commercial paper by 26 per cent from a year ago, according to the TBAC report. They’re using currency swaps and issuing longer-term dollar debt instead. But banks no longer have unlimited room on their balance sheets. So currency swaps have gotten more expensive, and traditional rules like covered interest-rate parity have broken down. From the report: Yankee banks, corporate taxes and the Fed’s impossible trinity: Here’s what we find most interesting: Central banks appear to be the only regulators attempting to alleviate these funding pressures, by continuing their push to become collateral intermediaries. The Basel Committee’s committee requirements put leverage limits on banks, which are traditionally the main arbitrageurs of global financial relationships (though hedge funds have picked up the slack in some areas). Then, the US’s main securities regulator introduced money-market fund reform that limited the size of the pool of dollars accessible to foreign banks. And if the corporate tax code is reformed, Congress might shrink it further. The Fed, on the other hand, has currency swap lines open with other major global central banks, so they can offer dollar liquidity to the banks headquartered in their countries. It has standing dollar and foreign-currency liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. Yet banks have been notably slow to take the Fed up on the offer of dollar liquidity, even as the market pricing of swaps gets more expensive. The Fed had just $201m of dollar liquidity swap operations outstanding with foreign central banks – in this case the ECB – during the week ended Nov. 16. There were $109bn in February 2012. The Fed acknowledged banks’ hesitation to use any central-bank liquidity (again) at its November meeting: The staff noted the importance of having effective arrangements to provide liquidity in times of stress. Stigma associated with borrowing from the discount window has likely prevented it from effectively enhancing control of short-term interest rates and improving liquidity conditions in various situations. Possible options to provide appropriate liquidity when necessary while mitigating such stigma were mentioned. Depending on who you ask, that means the Fed is either (1) acknowledging that facilities like the discount window and swap operations should become a bigger source of liquidity or (2) trying to lull banks into a complacency that would make them more likely to alert regulators in times of stress. Pozsar thinks it’s the former (our emphasis and link): Of course, if the Fed were to switch from treating the swap lines as a funding backstop to a pricing backstop, its attitude toward being tapped would have to be relaxed. In English, this means that long held notions of stigma would have to be expunged from the market’s conscience and everyone would have to adopt a mindset where if banks’ quotes are more expensive than the quotes of the Fed, everyone would default to trading with the Fed with no further thought, period – much like the ECB’s repo facilities are routinely tapped. Will this really happen? It’s not unlikely. We know from the July FOMC minutes that the Fed is actively looking into “approaches to reducing perceived stigma associated with borrowing at the discount window” and is conscious that “the dollar is the principal reserve currency and that monetary transmission in the US occurs through globally connected funding markets”. The Fed’s ongoing review of its Long-Run Monetary Policy Implementation Framework (to be published in January) may conclude the Fed should become a Dealer of Last Resort and be willing to make markets once spreads hit certain levels (the “outside” spread). If the Fed does end up taking a bigger role in global dollar financing, that would ostensibly help narrow the Libor-OIS spread as well. That spread is traditionally seen as a gauge of perceived bank creditworthiness. But following the logic of Pozsar’s note, it has become a way to measure the regulation-driven gap between the cost of onshore dollar financing (OIS rates) and offshore eurodollar financing (Libor rates).