Global markets face amplified dollar squeeze as U.S. rates rise

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Global dollar squeeze and U.S. rates

Highlights

Reduced Gulf petrodollar recycling, due to war disruptions and higher domestic spending, is limiting offshore dollar availability despite elevated oil prices.
China has shifted over 50 percent of its overseas bank lending to renminbi from less than 15 percent in four years, reducing demand for dollars in global lending.
Shrinking offshore dollar liquidity, amid tighter Fed policy and increased U.S. Treasury funding needs, is heightening dollar funding stress risks across emerging markets and non-U.S. banks.

Offshore dollar supply tightens in the Gulf and China

As reported by Financial Times, the global dollar system is coming under added pressure because U.S. Federal Reserve tightening is coinciding with weaker dollar recycling from the Gulf and a shift in China’s external financing patterns. The article argues that these two changes are removing cushions that have historically softened the impact of higher U.S. rates on the rest of the world.

In the Gulf, higher oil prices would normally lift current account surpluses and generate more petrodollars for investment in dollar assets. But the Iran war, the closure of the Strait of Hormuz and disruption to production and refinery facilities are curtailing exports, limiting the amount of dollars the region is generating.

Gulf states are also keeping more dollars at home to rebuild infrastructure, raise defence spending and support domestic economies. That means fewer petrodollars are available to meet dollar demand across international markets.

China is adding to that shift in a different way. Although its trade surplus is at record levels, Beijing is prioritising the internationalisation of the renminbi and is pushing the use of its own currency, rather than the dollar, for overseas lending and investment.

Chinese banks have increased renminbi-denominated overseas lending from less than 15 per cent of total overseas lending to more than half over the past four years, citing a Reserve Bank of Australia study. Lower interest rates on renminbi debt are also supporting borrowing demand in that currency, particularly across the global south.

At the same time, China’s capital outflows are tending to stay in Hong Kong through channels such as Southbound Bond and Stock Connect, which allow mainland investors to buy bonds and equities there. One sign of excess liquidity in the territory is that one-month HIBOR in Hong Kong dollars is about 2.7 per cent, below the roughly 3.9 per cent U.S. Secured Overnight Financing Rate over a comparable term, despite the Hong Kong dollar’s peg to the U.S. currency.

Hong Kong’s active initial public offering market is also helping keep funds in the territory. KPMG estimates fundraising there is on track this year to surpass the 2010 record of HK$449.5 billion, with many Chinese issuers keeping proceeds in Hong Kong or sending them back to the mainland instead of recycling more capital into New York or London.

Funding stress risks spread across global markets

These shifts are becoming more significant because they are arriving alongside tighter Fed policy, larger funding needs from the U.S. Treasury and rising capital demand from AI hyperscalers. Together, those factors are increasing concern that offshore dollar liquidity is shrinking just as competition for dollar funding is intensifying.

When offshore dollars become scarcer, stress can appear in cross-currency swaps, in borrowing costs for emerging-market issuers and in the balance sheets of non-U.S. banks that finance long-term dollar assets with short-term dollar liabilities. Research by Bank of Korea Governor Hyun-Song Shin, formerly head of research at the Bank for International Settlements, has also shown that dollar funding strains can build offshore in foreign exchange swap markets and among non-U.S. hedgers even when U.S. money markets appear calm.

The most severe example was during the 2008 financial crisis. There were also signs of pressure in 2020, although the disruption was less acute because the Fed responded more quickly through U.S. dollar swap lines with major central banks and a repo facility for foreign official holders of Treasuries.

If strains emerge again, the article suggests global markets may need an even faster and more forceful Fed response. It adds that such a response is not guaranteed in the current U.S. political environment.

In our earlier report on how Strait of Hormuz shipping disruption is hitting global food supply chains, we noted that delays and higher transport costs were already reducing fertilizer use, weighing on harvests, and pushing up agricultural commodity prices. We also highlighted that Asia and Africa face elevated food-security risks as prolonged uncertainty forces farmers and import-dependent economies to adjust planting decisions and supply routes.

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