The recent increases in U.S. interest rates are having a pronounced impact on global markets, extending beyond the commonly discussed effects on U.S. growth and asset prices to the broader mechanics of the global dollar system. As the Federal Reserve tightens monetary policy, dollar liquidity—which facilitates international trade and finance—is contracting by design. This tightening comes at a time when two traditional sources of offshore dollar liquidity, the Gulf states and China, are supplying fewer dollars than usual.

Historically, the Gulf region has recycled large current account surpluses into dollar assets, supported by oil revenues. While recent geopolitical events such as the Iran war have pushed oil prices higher, the closure of the Strait of Hormuz and disruptions to production and refining have significantly reduced oil exports. This has constrained the dollar inflows generated by Gulf countries. Additionally, increased domestic spending requirements—including infrastructure reconstruction, defense, and economic support—are prompting Gulf states to retain more dollars locally, leaving fewer dollars available to support global demand.

In parallel, China’s expanding trade surplus would typically translate into greater overseas dollar investment and lending. However, Beijing’s strategic push to internationalize the renminbi has shifted the landscape. Chinese banks have steadily increased renminbi-denominated overseas lending, which now accounts for more than half of their foreign loans compared to less than 15 percent four years ago. This trend, driven partly by lower borrowing costs in renminbi compared with dollars, has bolstered demand for yuan financing, particularly in emerging markets.

China’s capital outflows are increasingly concentrated in Hong Kong, facilitated by mainland initiatives such as the Southbound Bond and Stock Connect programs. These mechanisms enable Chinese investors to trade and invest in Hong Kong’s bond and equity markets while keeping funds within the region. Evidence of this liquidity concentration is reflected in the significant divergence between Hong Kong dollar interbank lending rates and comparable dollar rates; despite the Hong Kong dollar’s peg to the U.S. dollar, one-month interbank lending costs in Hong Kong dollars remain substantially lower than those in U.S. dollars.

Hong Kong’s active initial public offering (IPO) market, fueled mainly by Chinese companies, also contributes to this dynamic. Funds raised through these IPOs tend to stay within Hong Kong or flow back to the Chinese mainland rather than being deployed into global financial centers such as New York or London, altering the traditional recycling of China’s trade surplus into dollar assets abroad.

These shifts in the Gulf and China compound the challenges posed by tighter U.S. monetary policy, increasing funding pressures faced by the U.S. Treasury and large technology companies with substantial dollar debt. The resulting contraction in offshore dollar liquidity can manifest as elevated costs in cross-currency swaps, higher borrowing costs for emerging-market issuers, and strains on non-U.S. banks that finance long-term dollar assets with short-term liabilities.

Research by Hyun-Song Shin, Bank of Korea governor and former head of research at the Bank for International Settlements, highlights that such dollar funding strains often accumulate offshore, particularly in foreign exchange swap markets and among non-U.S. hedgers, even when domestic U.S. money markets appear stable. Historical episodes like the 2008 financial crisis underscore the risks of sudden dollar liquidity shortages. Although the Federal Reserve’s swift policy response during the 2020 market stress—through expanded dollar swap lines with major central banks and repo facilities—helped mitigate the impact, similar or greater strains in the future may require equally decisive Fed action. Whether the current U.S. political environment allows for such a response remains uncertain.