U.S. Fed Must Go Slow With Balance Sheet Unwind, Urjit Patel In FT

Urjit Patel’s message to the Fed: Slow down balance sheet unwinding or face a crisis in the dollar bond markets.

Urjit Patel, governor of Reserve Bank of India. (Photographer: Dhiraj Singh/Bloomberg)
Urjit Patel, governor of Reserve Bank of India. (Photographer: Dhiraj Singh/Bloomberg)

The dollar bond market will face a crisis unless the U.S. Federal Reserve slows down the unwinding of its balance sheet, according to Reserve Bank of India Governor Urjit Patel.

“Given the rapid rise in the size of the U.S. deficit, the Fed must respond by slowing plans to shrink its balance sheet,” Patel wrote in an opinion column in the Financial Times titled ‘Emerging Markets Face A Dollar Double Whammy’. “If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond market is inevitable.”

Patel said the “turmoil” in the dollar funding of emerging markets is not because of the U.S. Fed moving interest rates, that have been rising since December 2016. “The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing U.S. Treasuries to pay for tax cuts,” he wrote.

So, the withdrawal of dollar funding by the Fed, as it reduces its reinvestment of income received, is proceeding at roughly the same pace as that of net issuance of debt by the U.S. government. Over the next few years, the government’s net issuance will stabilise, albeit at a high level, whereas the Fed’s balance sheet reduction will keep rising.
Urjit Patel In Financial Times

That’s resulted in a “double whammy” for the global market, said Patel. “Dollar funding has evaporated, notably from sovereign debt markets. Emerging markets have witnessed a sharp reversal of foreign capital flows over the past six weeks, often exceeding $5 billion a week. As a result, emerging market bonds and currencies have fallen in value,” he said.

Patel said the U.S. Fed needs to “simply recalibrate its normalisation plan” to reduce the pace of its balance sheet contraction “by enough to damp significantly, if not fully offset, the shortage of dollar liquidity caused by higher U.S. government borrowing”.

“Such a move would help smooth the impact on emerging markets and limit effects on global growth through the supply chains that span both developed and emerging economies. Otherwise, the possibility will increase of a ‘sudden stop’ for the global economic recovery,” he wrote.