Macroscan. Can the Fed propel the wheels of global finance?

In its recently released update to the Global Financial Stability Report for April 2020, the IMF has expressed concern about the contrasting movements in real economy and financial indicators. At issue here is the rather quick recovery in equity and bond markets after the initial crash triggered by the crisis induced by the pandemic. In the words of senior IMF officials Tobias Adrian and Fabio Natalucci: “After sharp declines in February and March, equity markets have rallied back, in some cases to close to their January levels, while credit spreads have narrowed significantly, even for riskier investments.”

The IMF attributes this unusual and paradoxical recovery to the massive infusion of cheap liquidity by central banks, that have cut interest rates and fattened their balance sheets to the tune of $6 trillion.

A major component of this action is the funding that the US Federal Reserve has made available against government and non-government securities to financial and non-financial firms in the US, allowing them access to liquidity at a time when asset markets turned sluggish.

But this alone cannot explain the trends in global financial markets. What is noteworthy is that financial markets outside the US, including in emerging economies, have also bounced back. Given the fact that the foreign exposure of financial investors residing in the US is substantial, financial and non-financial firms in non-US jurisdictions need dollar funding to meet their dollar payment commitments to these investors. If a crisis-induced flight of investors results in dollar funding shortages in markets outside the US, and non-US firms default on their commitments, it would not only destabilise their markets, but also affect firms exposed to assets in these countries.

Moreover, investors from these jurisdictions, who have invested in dollar assets, would reconsider and possibly retreat to meet commitments at home. In sum, ripple effects could transmit the instability in these markets back to the US.

US Treasuries

Recognising this, the Fed decided to extend its liquidity infusion policy globally. One way it did this was to say that any central bank holding US Treasuries could access dollar liquidity against those bills from the Fed. Ever since the 1997 South-East Asian financial crisis, emerging markets have focussed on accumulating large foreign exchange reserves as insurance against any balance of payments shock or sudden flight of capital. A significant proportion of those reserves are held in US Treasuries. India, for example, holds around a third of its $500-billion reserves in US Treasury bills.

So, the decision to allow central banks to borrow dollars against Treasury bills through the Fed, at a much-reduced rate of interest, improves the dollar funding situation in a country. It also provides access to foreign exchange without reducing the level of reserves, which could send adverse signals to investors.

Swap arrangement

In addition, by using an instrument that it had successfully deployed earlier — especially during the 2007 global financial crisis — which is the opening of swap lines with central banks outside the US, the Fed has further increased access to dollar funding in global markets. The Fed has standing dollar liquidity swap lines since October 31, 2013, with a selected few central banks — the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. But in response to the Covid-crisis, it substantially enhanced the spread and size of its swap lines. On March 19, the Fed entered into temporary, six-month swap line arrangements which will support the provision of US dollar liquidity in amounts up to $60 billion each for the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Korea, the Banco de Mexico, the Monetary Authority of Singapore, and Sweden’s Sveriges Riksbank; and $30 billion each for the central banks of Denmark, Norway and New Zealand.

The swap involves two transactions: one involving the sale of a specified volume of the domestic currency of the applicant to the Fed for dollars at the prevailing market (spot) exchange rate; and the second a buyback on a specified date in the future of the domestic currency with dollars paid by the foreign central bank, at the same exchange rate.

When the second transaction is completed, the foreign central bank also pays interest at a market-related rate, depending on the duration for which it has drawn on the swap line.

As an arrangement, a swap line allows the central banks that have been provided the facility to access dollar funding at short notice. They can use those funds directly or lend it to financial institutions in their jurisdictions which are in need of dollar funding but are unable to easily access them from markets. The credit risk on such lending is carried by the foreign central bank, and the Fed does not carry any foreign exchange risk since the sale and repurchase of the foreign currency to and from the Fed is at the same exchange rate. Yet, in essence, when it comes to dollar funding, the Fed is taking over a part of the ‘lender of last resort’ function of selected foreign central banks.

Stabilisation of markets

The fact that this provision has made a difference comes through from the use of the swap lines as soon as they were enhanced. From $45 million on March 18, amounts outstanding against available Fed swap lines rose to $162.5 billion on March 19 and then climbed to a high of $449 billion on May 22 (Chart 1), helping stabilise markets outside of the US. As Chart 2 shows, the Bank of Japan and the European Central Bank, covering jurisdictions that are home to agents exposed substantially to dollar assets and liabilities, were the dominant users of the swap lines.

But emerging markets, with newly established swap lines, were also significant players — led by Korea, Singapore and Mexico (Chart 3). The trends depicted in the charts show that the use of swaps was in most cases temporary, with reliance on the instrument declining once markets were stabilised.

There is another factor explaining this role of swaps as a source of short-term support. Once they stabilise markets and investors turn confident and even complacent, the revival of investments itself triggers a recovery and even boom in markets. That recovery can occur even in countries like India, which was not a direct beneficiary of a swap line. As Adrian and Natalucci of the IMF argue: “Investors seem to be betting that lasting strong support from central banks will sustain a quick recovery.”

But, on the ground, the chances of a near-term recovery seem bleak, especially given uncertainty about how long the pandemic will last and whether countries that appeared to have seen the worst will experience a second wave. If the latter happens, the real economy recession could persist and intensify, upsetting the bets placed by financial investors and ending the paradoxical coexistence of vibrant financial markets and sluggish real economies.