Observations, arguments, scenarios, and implications

Central Bank Liquidity Swap – More Elaboration

Posted in 3 Ecofin by Minseok Marcelino Lee on March 13, 2010

*I wrote down many incoherent sentences for brainstorming, and I put them down in the paragraphs below. Although it is not completely coherent as a whole for now, I will work on the structuring as I read more research papers and data.

Goal: In this paper, I would like to explain why central banks around the world might want to cooperate in making appropriately (larger-)scaled central bank liquidity swap lines available between one another. I expect flexibly expandable large-scale central bank liquidity swap lines to help stabilize international finance system in an efficient manner.

In the global market turbulence post-mortgage crisis and Lehman’s collapse (2007-2008), foreign exchange market had volatile time just like most other markets. Because each nation has its own belief and method of managing its domestic currency, the forex market has been carefully watched by governments and central banks though in different degrees depend on each one’s currency management style. Central bank liquidity swap, arranged between the Federal Reserve (hereafter, the Fed) and other central banks from December 2008 to February 2010, is one of the instruments used to stabilize the international finance system. In this paper, I (expect to) argue that central bank liquidity swaps: one being dollar liquidity swaps and the other being foreign-currency liquidity swaps, are relatively low-risk (given that the counterparty risk is minimized by choosing the reliable dealing party) and flexible but under-utilized; hence the swap lines must be expanded to its maximum capacity.

The Fed operates these swap lines under the authority of the Federal Reserve Act and in compliance with authorizations, policies, and procedures established by the Federal Open Market Committee (FOMC). The FOMC has authorized the swap arrangements between the Federal Reserve and the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, Norges Bank, the Monetary Authority of Singapore, Sveriges Riksbank, and the Swiss National Bank. Central bank liquidity swaps were not in use from 2003 to 2006; however, from December 2007 to February 2010, the swap lines were created between the Federal Reserve and the European Central Bank, Swiss National Bank, and many other central banks, those whose foreign reserves are overstocked (ironically… but! there is causality, here).

In this paper, I argue that effective cooperation among the central banks of major economies will allow them to benefit the participants of central bank liquidity swaps.

US can reinforce dollar confidence (and there are many other countries that benefits from this aspect, biggest beneficiary being Asian countries who overstocked their reserve with USD denominated assets), and those whose exposure to international trade is significant can benefit from not having to build much more reserve than ‘needed’ for the foreign exchange market intervention purpose to reduce short-term volatility of the market.

When the swap lines are big enough, speculators will be scared away from holding large position against the currency regime’s will. This makes speculative attack practically impossible.

I expect the tricky part of these arrangements to be revealing how reliable can the central banks be to each other in terms of their condition of balance sheet (as we see in Greek and Italian case – this part seems resolvable not so difficultly: clearly, each central banks should be allowed to assess the counterparty risk and decide whether they want it or not; this way, central banks will be able to audit each other, in a way. This helps, again.) More difficult part would be finding out how international community would build trust with each other that these swap lines will not be used as a tool for international coercion.

Limitation/ irony: The more foreign currency reserve a currency regime holds, the less needed the swap line; however, the more reliable for the counterparty to set up the large-scale swap line. Therefore, this will not resolve short term liquidity problem of nations with small reserve.. which means my expectation that ‘the foreign reserve won’t have to be overstocked with large swap line’ may be wrong.
Digression: if China wants CNY to be used as a key currency at some point, one effective policy would be building global large-scale central bank swap line network.


I will write down which specific factor that I would like to calculate here. In fact, I believe that is the part where most work is needed to be done and most help is needed.

I seek to compare each countries’ foreign reserve relative to ‘something:’ I expect this to be the domestic currency – dollar (and other major currencies) exchange market size.

Calculating how much welfare improvement the countries with ‘too much’ foreign reserve will be able to enjoy if much less of their foreign reserve were meant to be used for the forex market intervention might be the goal of the paper.

I seek to examine ‘impact of swap contracts (news)’ to the market – this seems quite challenging, as it might be very difficult to come up with all the needed control variables. Also, I expect the magnitude of the CB Swap Impact much smaller (and also deflated due to the relative size of the swap lines vis-a-vis… reserve?) than of many other core factors… Hmph, sian, -_- how would I do this?

I do not seek to find out specificly where those excess reserve mihgt be used, as it is not the main goal of the paper. (or, do you think it might be necessary?)

I suppose I am still at the brainstorming stage.

Data expected to be used:=========================

http://www.bis.org/publ/qtrpdf/r_qt0812.htm (Page 15)



+ IMF and World Bank data for Foreign reserve, currency rate, IMF reserve data

4 Responses

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  1. minseok said, on March 13, 2010 at 4:30 pm

    In history, there were cases when the nations suffered from poorly arranged CB swap lines. It might be worth paying attention to some of those cases…

  2. minseok said, on March 13, 2010 at 5:32 pm

    add (Much more investment could be done..)

  3. minseok said, on April 8, 2010 at 12:21 pm

    Good call:

    Singapore chosen to host East Asia’s 1st economic surveillance office+

    4/7/2010, 9:00 a.m. EDT

    The Associated Press

    (AP) — NHA TRANG, Vietnam, April 7 (Kyodo)-ASEAN finance ministers have chosen Singapore as the location for East Asia’s first ever economic and financial surveillance office, which will run a US$120 billion multilateral currency swap scheme to ward off future regional financial crises, ASEAN sources said

    The decision made by consensus among ministers of the 10-member Association of Southeast Asian Nations at their informal meeting here Wednesday follows months of fierce competition among Thailand, Singapore and Malaysia to host the high-powered regional surveillance office.

    The office, currently referred to as the ASEAN-plus-three Macroeconomic Research Office or AMRO, is expected to be established by May next year to run the Chiang Mai Initiative, which involves cooperation among ASEAN members, Japan, China and South Korea.

    It is expected to monitor economic developments in the region and also make urgent decisions on the activation of a reserve fund to help defend regional currencies in times of financial turmoil.

    Singapore had a strong edge over other contenders because of its efficient infrastructure as a business and financial center, ASEAN officials said. The city-state scored highly in an assessment that the Jakarta-based ASEAN Secretariat commissioned international consulting house Ernst & Young to conduct recently.
    Thailand had been lobbying strongly in the last few months on the grounds that the Chiang Mai Initiative was established as a regional network of bilateral swaps by the 13 East Asian nations in Chiang Mai, Thailand, in 2000 in response to the 1998 Asian financial crisis that had battered some economies in the region badly.

    It had also proposed and offered a couple of sites to be used by the new office free of charge, officials said.

    It is understood that some ASEAN governments had earlier favored Thailand due to its lower business cost compared with Singapore. But Thailand’s political uncertainties could have stood against it.

    An ASEAN official attributed the three countries’ drive to host the office to the perceived prestige of hosting what could potentially grow in stature to become an Asian version of the International Monetary Fund someday. But at least for the moment, officials see its role as just to complement the IMF.

    The decision is expected to be announced by the ASEAN finance ministers at the end of their meeting here on Thursday.
    In February last year, the finance ministers of the 13 East Asian countries involved in the Chiang Mai Initiative agreed to raise the reserve fund from US$80 billion to US$120 billion, with ASEAN countries contributing US$24 billion and China, Japan and South Korea shouldering the rest.

    The ASEAN finance ministers are expected to meet their three East Asian partners on the sidelines of the Asian Development Bank annual meeting that will be held in Tashkent, Uzbekistan, in early May.

    ASEAN groups Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam.


  4. minseok said, on May 11, 2010 at 6:22 am

    Fed Restarts Currency-Swap Tool With ECB in Effort to Contain Debt Crisis
    By Scott Lanman and Craig Torres – May 10, 2010

    The U.S. Federal Reserve will restart its emergency currency-swap tool by providing as many dollars as needed to European central banks to keep the continent’s sovereign-debt crisis from spreading.

    The swaps with the European Central Bank, Bank of England and Swiss central bank, as well as the Bank of Japan, will allow them to provide the “full allotment” of U.S. dollars as needed, the Fed said late yesterday and today in statements in Washington. A separate swap line with the Bank of Canada will support as much as $30 billion, the Fed said. The swaps were authorized through January 2011.

    The Fed action was a complement to European policy makers’ announcement of an unprecedented loan package worth almost $1 trillion to stop a crisis that threatened to shatter confidence in the euro. The U.S. central bank on Feb. 1 had closed all swap lines opened during the last crisis, triggered by the subprime- mortgage meltdown in 2007.

    “If there is one thing the Fed doesn’t like, it is systemic risk,” said Torsten Slok, an economist at Deutsche Bank AG in New York. “Early signs of systemic risk were brewing in the financial system last week, and if policy makers had not taken action this weekend, then this would also have been a threat to the U.S. financial system.”

    Stocks surged around the world today after yesterday’s actions, with the Standard & Poor’s 500 Index rising 3.8 percent to 1,152.79 at 1:29 p.m. in New York. The euro strengthened against the dollar, gaining 0.4 percent to $1.2807 after rising as much as 2.7 percent. The euro traded at $1.5134 in November.

    Stress Sign

    In a swap, central banks exchange foreign currency with an agreement to reverse the transaction at a later date. The central banks will then lend the dollars at fixed rates to firms in their countries. Dollar liquidity tightened in London last week amid concern financial institutions are holding too many assets of Europe’s most-indebted nations.

    “My concern was whether or not the financial concerns for financial institutions in Europe would spill over into the United States and affect our incipient recovery,” Philadelphia Fed President Charles Plosser said today in an interview on CNBC. “Hopefully the actions that have been taken will prevent that from happening, and the Fed’s role in this, in renewing the swap lines, was an effort to help ensure that that didn’t happen.”

    Libor Fell

    The London interbank offered rate, or Libor, for three- month loans slipped to 0.421 percent today, from 0.428 percent on May 7, the highest since Aug. 17, according to the British Bankers’ Association.

    Plosser said his U.S. economic outlook is “still pretty upbeat” and projected average job growth of about 250,000 to 300,000 positions a month for the rest of the year.

    Fed officials aren’t sure what the immediate demand will be for dollars or how much the U.S. central bank’s balance sheet will grow from its current level of $2.33 trillion. The ECB said its first offering will take place tomorrow. The prior incarnation of the swaps peaked at $583.1 billion in December 2008, with deals encompassing 14 other central banks.

    “We have a banking system that is fragile, and those banks are exposed to European banks,” said David Kotok, chairman and chief investment officer at Cumberland Advisors Inc., which manages about $1.4 billion in Vineland, New Jersey. Further volatility in Europe would “impact us as well,” he said.

    Rising Costs

    Rising costs in the market for dollar loans between banks began to show “distrust” in the financial system, Kotok said. “As soon as you see that, you know you have systemic risk.”

    This time, the Fed’s swaps come amid increasing political scrutiny. Congress could ask why the U.S. central bank is expanding the supply of dollars to help smooth disruptions caused by fiscal imbalances in Europe.

    Senator Bernard Sanders, a Vermont independent, wants the Government Accountability Office to look into Fed lending facilities during the crisis, including swap lines with foreign central banks, such as the $20 billion facility the Fed opened with the ECB in December 2007.

    A vote on the Sanders amendment could come as soon as May 11 as Congress proceeds with the most sweeping overhaul of financial regulations since the Great Depression.

    “Many members of Congress are deeply suspicious of the Fed’s interventionist instincts,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “Bailing out Wall Street caused enough resentment; appearing to bail out Greece would be even more problematic.”

    ‘Rile Up’

    “The Fed cannot afford to rile up its congressional critics while the financial reform bill is still in play,” Crandall said before tonight’s announcement.

    The Fed said today it’s not at risk of any losses on the swaps, because the ECB is obligated to repay the dollars the Fed provides at the same exchange rate.

    The weekend’s events had echoes of the financial crisis in 2008. Fed policy makers acted after getting formal requests from the other central banks late on May 8, a Saturday, following informal requests toward the end of last week. The FOMC convened a meeting around midday yesterday and delegated authority, with conditions, for Chairman Ben S. Bernanke to approve the swaps. The vote of Fed policy makers was unanimous.

    Fed officials considered possible political consequences of their decision at their weekend meeting. Bernanke told his colleagues that the Fed had to do what is right for the U.S. economy, while providing more transparency to Congress. The Fed said it will publish weekly reports on the swaps and will “shortly” release the contracts with the other central banks.

    Many Risks

    Officials at the Fed saw multiple risks to the U.S. expansion from continued turmoil in Europe, such as crimped trade, declining confidence, and financial volatility.

    The Fed’s move may pale next to the agreement by the 16 euro nations to offer financial assistance worth as much as 750 billion euros ($971 billion) to countries under attack from speculators. The ECB said it will counter “severe tensions” in “certain” markets by purchasing government and private debt.

    “The Fed action is a fringe development here,” said Axel Merk, president and chief investment officer of Merk Investments LLC in Palo Alto, California. The more important development is that “Europe is getting its act together,” he said.

    To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net.


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