“While the world economy is being reordered, the U.S. dollar remains as important as when Bretton Woods collapsed.” Mark Carney, former Bank of England Governor, Jackson Hole speech, August 23, 2019.
In his comments at Jackson Hole last year, then-Bank of England Governor Mark Carney highlighted the continuing dominance of the U.S. dollar: it accounts for one-half of global trade invoicing; two thirds of emerging market external debt, official foreign exchange reserves, and global securities issuance; and nearly 90 percent of (one leg of) foreign exchange transactions.
It also is the basis for the Global Dollar system (see our earlier post). The BIS reports that short-term U.S. dollar liabilities of non-U.S. banks total $15 trillion. Foreign exchange forward contracts and swaps—with a gross notional value of more than $75 trillion—add substantially further to U.S. dollar exposures (see here). And, the U.S. Treasury reports that foreigners hold more than $7 trillion of U.S. Treasury securities. To put these numbers into perspective, total assets of U.S. depository institutions are currently $20 trillion. In other words, the U.S. dollar financial system outside of the United States is larger than the American banking system.
Like it or not, the Federal Reserve is the dollar lender of last resort not just for the United States, but for the entire world. The Fed’s role is not altruistic. Instead, it reflects the near-certainty that, in a world of massive cross-border capital flows, dollar funding shortages anywhere in the world will spill back into the United States through fire sales of dollar assets, a surge in the value of the dollar, increased domestic funding costs, or all three. Put differently, when there is a run on dollar liabilities outside the country it poses a clear threat inside the country. So, the Fed has to care.
While much of its extraordinary efforts to counter the COVID-19 crisis are completely domestic, the Fed also has taken aggressive actions to counter dollar shortages in key advanced economies. In this post, we explore those actions, including the supply of dollar liquidity swaps to 14 central banks (“friends of the Fed”) and—to limit sales that might disrupt the Treasury market—the introduction of a repo facility to provide dollars to the others. We also note the challenges facing countries outside the small inner circle that do not have immediate access to the Fed’s swap lines.
Starting with the swap lines, to provide dollar liquidity abroad, the Fed now offers 14 central banks dollars for up to 12 weeks at the overnight index swap (OIS) rate plus 25 basis points. (The most recent 7-day operation, on April 30, had an interest rate of 0.29 percent.) In return, the Fed receives foreign currency of equal value in the form of a deposit at the foreign central bank. At maturity, these funds are swapped back at the original spot market value, and the foreign central bank pays the interest. In effect, the Fed is making a loan collateralized by the foreign currency deposit with no exchange rate risk. To the extent that there is any credit risk, it arises from the possibility that the foreign central bank will not be able to return the dollars and that the collateral will not offer sufficient value―circumstances in which the sovereign would likely have defaulted as well. (For further details on the operation of the swap lines, see here and here.)
After receiving dollars from the Fed, the foreign central bank proceeds to lend them on a collateralized basis to their domestic intermediaries that seek dollar funding. Consequently, the foreign central bank that “knows its customer” (and can most effectively enforce its priority among creditors) bears the credit risk of lending to private intermediaries. In recent weeks, these operations have been quite large. For example, as of April 24, the European Central Bank (ECB) had made €150 billion of loans to euro area residents denominated in foreign currency, up sharply from just €22 billion in mid-March, but below the peak of €249 billion in early December 2008. (See the ECB balance sheets here, here, and here.)
Dollar swap lines first came into wide use in the crisis of 2007-09. At the time, banks outside of the United States faced extreme dollar shortages: one estimate put them over $1 trillion. The provision of swap lines, initially in December 2007 with four foreign central banks, eventually expanded to include 14, while outstanding dollar loans peaked in December 2008 at nearly $600 billion (see the chart below). Since then, the Fed has maintained standing arrangements with five central banks: the Bank of Canada, the Bank of England, the ECB, the Bank of Japan (BoJ), and the Swiss National Bank. These five facilities are unlimited in scale. On March 19, 2020, the Fed added volume-limited swap facilities for the nine other central banks (for at least six months) that had previously received this privilege during the crisis of 2007-09. As of April 29, the Fed’s swap lines had surged to $439 billion, up from only $45 million just six weeks earlier.
Federal Reserve central bank liquidity swaps (Wednesday levels, billions of dollars), 2007-April 29, 2020
Notes: Gray areas depict recessions. Source: FRED.
So, are the swap lines helping to alleviate dollar funding pressures outside of the United States? In the advanced economies, the answer is unambiguously yes. To see this, we start with a reliable market indicator of dollar shortage—namely, the cross-currency (FX) swap basis. In this market, traders exchange the returns on claims in the two currencies as well as the principal at the start and end of the trade (for a complete description, see Du, Tepper and Verdelhan). The spread that swap parties pay to receive dollar cash flows in exchange for euro or yen cash flows is the FX swap basis. You can think of this as the difference between the U.S. interest rate and a synthetic dollar interest rate received from a foreign-currency-denominated investment. In theory, if the parties have zero default risk and if they have no cost of putting the loan on their balance sheet, the swap basis should be virtually zero (see our earlier post on covered interest parity).
The following figure shows the evolution of the FX swap basis since 2006 for three-month dollar/euro and dollar/yen swap contracts (based on LIBOR interest rates). Importantly, when the swap basis is below zero, swap market participants are paying a heightened fee to obtain dollars, indicating that they are in short supply. Looking at the left-most portion of the chart below, we can see that there is little evidence of a significant dollar shortfall prior to the 2007-09 crisis. Indeed, at the time, covered interest parity (CIP)—consistent with a basis of zero—was widely perceived to be a risk-free arbitrage. During the 2007-09 crisis, however, CIP deviations arose across a wide range of currencies (see, for example, Baba and Packer). The dollar shortfall peaked just after the September 2008 failure of Lehman. (Deviations arose again during the euro-area crisis in the autumn of 2011.) Recently, the dollar shortfall has been especially notable in Japan. On March 16, 2020, the yen/dollar swap basis reached its lowest point since October 1, 2008.
Three-month FX swap basis: dollar-euro and dollar-yen (daily, basis points), 2006-May 1, 2020
Source: Courtesy of the Bank for International Settlements.
To see the impact of the Fed’s dollar liquidity swaps, we can take a close look at developments since mid-March. The following chart depicts the same euro and yen swap basis, and adds the volume of the Fed’s dollar swaps with the ECB and the BoJ. Following the March 15 coordinated announcement among the five central banks eligible for unlimited dollar swaps, the volume began to surge (see the first chart). Initially, the ECB and the BoJ accounted for about 90% of the total. As of the end of April, they still constitute more than 80% of the outstanding $446 billion. Looking at the pattern in the following chart, we can see that the outsized role of these two central banks in the swap operations is consistent with the shrinkage (in absolute value) of the dollar-yen and dollar-euro swap basis. In fact, as the volume continued to rise in March, the swap basis moved into positive territory, signaling a temporary dollar surplus. By the end of April, there was little evidence of either a dollar funding excess or shortage.
Three-month FX swap basis (daily, basis points, dashed lines, right axis) and volume of Fed dollar liquidity swaps with the Bank of Japan and the European Central Bank (billions, bars, left axis), February 6, 2020 to April 30, 2020
Sources: Federal Reserve Bank of New York (liquidity swaps) and courtesy of the Bank for International Settlements (swap basis).
So, for the chosen 14, the Fed is the lender of last resort standing ready to provide dollar funding should a shortage arise. What about everyone else? For them, there is the new repo facility. On March 31, following a one-month decline of $150 billion in foreign official custody holdings of Treasuries at the Fed, as well as heightened volatility in the Treasury bond market, the Fed announced a new (temporary) repo facility to reduce the incentive for official sales of Treasuries and to smooth market conditions. The FIMA Repo Facility (for foreign and international monetary authorities) allows official accountholders to use their Treasury securities held in custody at the New York Fed to obtain dollars. The new facility offers dollars at a rate of 25 basis points above the interest rate paid on commercial bank reserve deposits (the IOER rate), which is currently 0.10 percent.
In effect, FIMA converts foreign central bank and government Treasury holdings into a contingent dollar facility that pays a fee when they do not exercise it (namely, the return on the Treasury securities). As the Fed notes, the fee charged for taking down credit “generally exceeds private repo rates when the Treasury market is functioning well.” Yet, by offering to lend without limit against good collateral at a modest penalty, the Fed is serving as a Bagehot lender of last resort in dollars for central banks that do not have access to the swap lines. In practice, with the Treasury market having settled in recent weeks, virtually no one has tapped the FIMA Facility: as of April 29, with $2.9 trillion in eligible securities held in custody at the Federal Reserve Bank of New York, there is only $2 million outstanding.
Despite its limited use so far, the long-term consequences of this new facility could be significant. For example, foreign central banks can now reasonably expect that in the next crisis there will be a FIMA-2. In order to ensure access to dollars, this creates an incentive for countries to shift the composition of their foreign exchange reserves toward U.S. Treasuries (and the dollar) and place them in custody at the New York Fed. Such a shift would further support the U.S. dollar, which already has appreciated notably in the crisis, expanding the “exorbitant privilege” of the United States as the monopoly provider of the global reserve currency (see our earlier post).
Nevertheless, it is doubtful that the Fed’s repo facility has put dollar shortages in the COVID-19 crisis to rest. The longer the crisis persists, the more likely it is that economies beyond those of the privileged 14 will find difficulty in meeting their dollar debts and sustaining their financial systems. Many of these are emerging economies that already are suffering both from the virus and from the plunge of global demand for their exports as well. While the FIMA facility can help those with Treasurys as collateral, the Global Dollar system has created trillions of dollars of liabilities for which such collateral does not exist. In these circumstances, the pressure will grow for the Fed to find ways to get dollars to those in need. Will there be a push to increase the number of countries eligible for dollar swap lines? Will there be an expansion of the collateral acceptable for the FIMA repo facility? Beyond the Fed, what about the liquidity facilities provided by the International Monetary Fund (see Setser)?
In the end, the Federal Reserve is the dollar lender of last resort to the global financial system. So far, U.S. central bank has managed to address shortages and calm markets. But should the needs become larger, more widespread, and more urgent, what will they do? They have the resources, but do they have the resolve?
We will see.