Handbook of Exchange Rates

23.3 Dislocations of the FX and Cross-Currency Swap Markets under Financial Crises

23.3.1 Japan Premium Case in the Late 1990s

In the autumn of 1997, concerns over the stability of the Japanese financial system heightened because of the nonperforming loan problem that had remained unsettled since the collapse of the asset bubbles in the early 1990s. Eventually, November of this year witnessed a series of failures of financial institutions: Sanyo Securities, Hokkaido Takushoku Bank, Yamaichi Securities, and Tokuyo City Bank.⁶

In the meantime, a premium that Japanese were required to pay over other banks in the offshore interbank US dollar funding market—so-called “Japan premium”—emerged around mid-October and then increased substantially toward the beginning of November in the wake of the failure of Sanyo Securities. This failure triggered downgrades in credit ratings of a wide range of Japanese financial institutions and the Japan premium reached a peak in the beginning of December 1997 (Covrig et al., 2004; Peek and Rosengren, 2001).

The extreme difficulty for Japanese financial institutions to raise US dollars in the offshore funding market made them turn to the FX and cross-currency swap markets. Owing to its effectively collateralized structure, the FX swap-implied dollar rate from yen was relatively stable, at least until early November.

Over time, however, one-sided order flow of US dollar funding made the FX and cross-currency swap markets dislocate as well, amid increased ...