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Abstract
A fundamental puzzle in international finance is the persistence of covered interest rate parity (CIP) deviations. Since 2008, these deviations have implied a persistent dollar financing premium for banks in the Euro area, Japan and Switzerland. Using a model of the foreign exchange (FX) swap market, I explore two channels through which the unconventional monetary policies of the European Central Bank, Bank of Japan and Swiss National Bank can create an excess demand for dollar funding.
In the first, quantitative easing leads to a relative decline in domestic funding costs, making it cheaper for international banks to source dollars via FX swaps, relative to direct dollar borrowing. In the second, negative interest rates cause a decline in domestic interest rate margins, as loan rates fall and deposit rates are bound at zero. This induces banks to rebalance their portfolio toward dollar assets, again creating a demand for dollars via FX swaps. To absorb the excess demand, financially constrained arbitrageurs increase the premium that banks must pay to swap domestic currency into dollars.
I show empirically that CIP deviations have tended to widen around negative rate and QE announcements. I also document a rising share of dollar funding via the FX swap market for U.S. subsidiaries of Eurozone, Japanese and Swiss banks in response to a decline in domestic credit spreads.