Dollar funding stress and the long-run structure of exchange rates

We test a new mechanism through which global dollar funding conditions alter the long-run structure of exchange-rate dynamics. We argue that tighter dollar funding conditions reduce intermediary risk-bearing capacity, increasing the equilibrium price of global dollar risk. As a result, exchange rates become increasingly driven by a common global factor, strengthening the visibility of reduced-rank exchange-rate dynamics while generating greater heterogeneity in currency exposures. We test these predictions using the cross-currency basis as a direct measure of international dollar funding stress. We observe that when funding stress is high, there is clearer evidence of reduced-rank exchange-rate dynamics and more variation in effective currency factor loadings. By contrast, the evidence for stronger common factor concentration is more modest, while long-horizon exchange-rate comovement changes little. These findings show that global dollar funding conditions affect both the level of exchange rates and their underlying stochastic structure. They also highlight that intermediary balance-sheet constraints play a key role in how exchange rates become integrated.