The US dollar's time to shine

Stratfor.com

The US Federal Reserve on Wednesday adjusted its "dollar liquidity swap arrangements" with Europe's central banks, as well as with Japan and Canada. This means that for now, European banks will not require a massive bailout that Europe is ill-equipped to provide. It also demonstrates the true nature of the US-dominated global financial order.

The Fed's action effectively gives these central banks access to a massive pool of new US dollars that they can borrow at low costs. Central banks will then provide funding to their banking sectors. The loans must be repaid to the Fed within three months and are structured so that the risks are borne by the foreign central banks, not the Fed. Similar arrangements have been used since the days following the 9/11 attacks and were deployed in the early stages of the US subprime crisis, but Wednesday's deal offers the best terms yet to borrowers. And loans like this are regularly refinanced as they expire.

The move generates relief amid rapid deterioration in the European financial markets as banks' holdings of distressed sovereign bonds decline in value. European banks cannot withstand serious declines in the value of their assets compounded by unwieldy amounts of leverage – borrowing money to purchase these bonds and other assets. In some cases even 2 per cent fluctuations in asset values could lead these banks into bankruptcy. In this environment, banks stop lending to each other, fearful that the borrower will go bankrupt and therefore be unable to pay back the loans.

Europe's intertwined banking and sovereign debt crises create a complex and unwieldy situation. The banks need governments to service what are basically unserviceable debt burdens or the banks will become insolvent. Governments, meanwhile, need banks to refinance their countries' growing debts or they will default. And on top of this sits a relatively constrained European Central Bank that does not have the wide latitude for action its counterparts in other economies have. There is a strong argument to be made that limitations on the ECB will ease as the crisis continues – they already have to a significant degree – but the stress in Europe's banking sector has reached a critical stage.

The proposed solutions are, for the most part, not clearly conceived – and all are improbable as long-term fixes. Sovereign wealth funds based in nations whose per capita incomes are a fifth of Europe's balked at providing funds. Investors who had already shunned European bond markets despite full sovereign guarantees could not be lured back with complex schemes involving only partial guarantees. The overall sense of futility has been growing.

Even though the Fed is merely providing liquidity, as opposed to long-term structural support, its action will do much to abate Europe's crisis. Nominally designed to support markets with short-term dollar loans, the funds provided by the currency swaps will find their way through numerous channels into the broader European financial markets. Thus, in addition to helping banks, the funds could relieve pressure on Europe's sovereign debt markets. For example, banks can purchase government bonds – even those, such as Greek bonds, that are very poorly rated – and use them as collateral to secure this unlimited funding. But even though the risk of a fundamental breakup in the banking sector or currency union will abate somewhat, none of the underlying problems that have created the crisis will have been solved.

In fact, it is Stratfor's standing forecast that nothing will solve the underlying problems that have created Europe's crisis. The European Union is an inherently desynchronised entity, and packing disparate economies like Germany and Greece into a free trade zone, let alone a currency union, is naturally problematic. Peripheral European countries cannot forever absorb unchecked German exports with no recourse to the traditional methods they have used to protect themselves – such as trade barriers, controls on capital flows and independent monetary policies.

Still, forceful backing from the United States is a significant geopolitical event in that it reinforces the established global financial and monetary order. The United States provided this type of liquidity to Europe in the past, in order to counter the effects of the US subprime crisis. Now, as countries watch Europe's crisis grow to threaten the eurozone's very existence, the United States is ultimately the only economy large enough and with enough political credibility to prop up the global system. This was a given for most of the postwar era, but was seemingly forgotten over the past decade as proponents of the euro touted the currency as a counterbalance to the dollar. But the facade of the euro's stability has begun eroding, and dollar primacy has begun reasserting itself.

Stratfor.com Reprinted with permission of STRATFOR.