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October 20, 2008

Where is My Swap Line?
by John Mauldin

The G-7 countries now have what amounts to access to the US Fed's window for dollars for their banks. But what of the rest of the world? Brad Setser, an analyst who writes a blog for the Council on Foreign Relations, ask some very interesting questions and points out some big holes in the world economic landscape. If you can't get dollars what does that do to your currency? This contributes to the rise in the dollar against some emerging market currencies. Setser asks: "Where is my swap line? And will the diffusion of financial power Balkanize the global response to a broadening crisis?"

You can read some of his other material at http://blogs.cfr.org/setser/. Setser is an applied international economist with experience at the U.S. Treasury and the International Monetary Fund. Currently examining central bank reserve growth, sovereign wealth funds, and the political implications of emerging market financing of the United States. Author of the recent Council Special Report, Sovereign Wealth and Sovereign Power.

John Mauldin, Editor
Outside the Box

Where is my swap line? And will the diffusion of financial power Balkanize the global response to a broadening crisis?
by Brad Setser

Some emerging market central banks have noticed that they - unlike the Bank of Japan, Bank of England, Swiss National Bank and the European Central Bank - don't have access to unlimited dollar credit through reciprocal swap lines with the Federal Reserve.

Peter Garnham of the FT, drawing on Derek Halpenny of Tokyo-Mitsubishi UFJ, observes:

Analysts say the unlimited dollar currency swaps set up between the Federal Reserve and central banks have helped bring stability to currencies through alleviating institutions desire to purchase dollars in the spot market to satisfy overnight funding requirements. "In contrast, the lack of currency swaps put into place between the Federal Reserve and emerging market central banks has likely helped to exacerbate the pick up in emerging market currency volatility" says Derek Halpenny, at the Bank of Tokyo Mitsubishi UFJ.

Think of Korea. There is "a shortage of dollars in the Korean banking system" - and Korean banks (and the Korean government) are scrambling to obtain them. That is likely adding to the pressure on the Won.

For all the talk about how the G-7 has lost relevance, in a lot of ways the recent crisis has reinforced the G-7's importance. Banks in G-7 countries that borrowed in dollars have access to unlimited dollar financing from their central banks - dollar financing that comes from the fact that the main G-7 central banks have access to large swap lines with the Fed.

Banks in emerging market countries have no such luck.

Korea is a highly developed emerging economy. In a lot of ways it already has emerged. But it isn't part of the G-7 (or G-10) and doesn't have a swap line with the Fed that allows the Bank of Korea to borrow dollars from the Fed by posting won as collateral. That means that it has to rely on its foreign currency reserves - and its government's capacity to borrow dollars in the market - to support its banks. Unless, of course, Korea could draw on a set of East Asian swap lines, and effectively borrow from Japan and China.

The old global architecture for responding to financial crises had, in my view, two essential components:

First, the major countries themselves were responsible for acting as the lender of last resort (and the bail-outer of last resort) to their own domestic financial system. Since the advanced economies banks' had liabilities denominated in their own countries' currency (US bank deposits are in dollars, British deposits are in pounds, and so on) this wasn't hard.

And emerging economies had to turn to the IMF (sometimes reinforced with "second line" financing from the G-7) for dollar (or DM or pound or Euro) financing - whether to help meet their government's own financing need, to help the emerging economies' central bank provide a "hard currency" lender of last resort to its domestic financial system or to provide the emerging economy more foreign currency reserves to backstop its currency.

And since emerging market governments often borrowed in dollars or euros rather than their own currencies - and since many emerging market savers held dollar or euro denominated domestic deposits - emerging economies often had a need for significant financing.

This financing though was never unconditional - and was never unlimited. The $35b the IMF lent to Brazil in 2002 and the $20-25b the IMF lent to Turkey in 00-01 seemed big at the time, but it now seems small.

That architecture has been extended in one key way in the crisis:

European and Japanese banks facing difficulties refinancing their dollar liabilities now have (indirect) access to the Fed. The availability of $450b in credit from the Fed allowed European central banks to lend dollars to their banks without dipping into their (comparatively modest) reserves.

Emerging market central banks generally haven't been as lucky. Their ability to lend dollars to their own banks is still limited by their own holdings of dollar reserves, their ability to borrow reserves from the IMF in exchange for IMF policy conditionality and their ability to borrow dollars from other emerging market economies with spare dollar reserves.

I am still trying to figure out how important a change this is - and to assess whether this new architecture makes sense for a global financial system that has changed fundamentally in some ways but not in others.

At one level, the stark divide between banks regulated by a the G-10 countries -- which now have access to the Fed as a lender of last resort, albeit indirectly -- and the banks regulated by the rest of the world seems a bit anachronistic. The center of the world economy won't always be in the US and Europe.

On another level, a higher level of cooperation is possible among countries with broadly similar political systems than among more diverse group of countries with different political and economic systems. Similar forms of government, broadly similar (though changing) conceptions of the state's role in the economy and a standing political alliance* facilitate the kind of cooperation among G-10 central banks that we have seen recently. Korea could presumably be drawn into the club without changing its basic character - Korea is a US ally and a democracy. Iceland could too, if it patches up its relationship with the UK - though the risk that Iceland's government now has more debt than it can pay makes accepting Icelandic collateral in exchange for dollars a bit more of a problem.

Adding emerging economies with different economic and political systems from the G-7 countries into the "swap line" club might fundamentally change its character. Among other things, the US and Europe basically agree that their currencies should float against each other -- and that they should regulate (or, until recently, not regulate) their financial systems in fairly similar ways.

There is another key difference between European banks' need for dollars and many emerging markets' need for dollars. European banks need dollars to finance their holdings of US mortgages and other US securities. If they didn't have access to dollar financing, they would either have to borrow euros and buy dollars - pushing the dollar up (and hurting US exporters) or they would have to dump their US assets (hurting US banks holding similar assets). By lending to European central banks who then lent to their own banks, the US kept some European banks from being forced sellers of risky US assets - and in the process putting pressure on US banks. The US wasn't acting entirely altruistically.

Emerging market banking systems by contrast often need dollar financing not to support their portfolios of US assets but to support their domestic dollar lending.

And it is now clear that a broad range of emerging economies do need access to the international banking system to continue the kind of breakneck growth that they have experienced recently -- and have been caught up in the recent "deleveraging" of the global financial system. The FT's Garnham again:

Analysts said emerging market currencies were being hit as foreign investors pulled money out of developing regions, driven by liquidity pressures from the credit crisis. "There seems little now that the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time," said Derek Halpenny, at Bank of Tokyo-Mitsubishi.

Hungary is scrambling for euros.

Ukraine's government is scrambling for dollars and euros - both to back its currency and to cover the maturing foreign currency borrowing of its banks.

Pakistan's government needs dollars.

Korean banks are scrambling for dollars.

Russian banks. And Kazakh banks. And Emirati banks.

In many of the oil exporters, the government was building up foreign currency assets (reserves, sovereign wealth funds) while the private sector (including many firms with close ties to the government) were big borrowers from the international banking system. In the Emirates there is an added complication: Abu Dhabi was the emirate building up its external assets, while Dubai was the emirate doing the most borrowing.

But across the emerging world, external bank loans have dried up - creating a scramble for foreign currency liquidity.

And emerging markets (and Iceland) are looking for help from a range of sources. Their own central banks' reserves (Korea, Russia, the Emirates) - or the foreign assets of their sovereign fund (Russia, China, Qatar, Kuwait, perhaps Abu Dhabi).*** The IMF, which is clearly back in business. European central banks (Hungary borrowed 5 billion euros from the ECB, the Nordics swap line with Iceland -- which was recently tapped for euro 400 million). Russia (if it lends to Iceland).

Or China. Pakistan was certainly hoping that China would offer an alternative to the IMF; China though does not currently seem to be willing to hand Pakistan a sum that is equal to a couple of days of its reserve accumulation ...

This frantic activity suggests another potential change to the global architecture for responding to crises: the IMF no longer necessarily has a monopoly on hard currency crisis lending to the emerging world. It is now one player among many.

That is a fundamentally a reflection of the increased reserves of many large emerging economies.

China clearly has more dollars than in needs to maintain its own financial stability, which means that it is an alternative source of dollar financing. Russia may be too - though the large dollar and euro liabilities of Russian banks and firms implies that its own need for reserves could be quite large. It isn't in as comfortable a position as China.

The diffusion of pools for dollar liquidity available to lend to troubled emerging economies seems at least to me to pose a fundamental issue for the G-7 countries that traditionally have been able to essentially decide on how the IMF's funds are used among themselves: does the diffusion of financial power a major effort to bring the big emerging powers into the IMF's fold - and thus to restore a de facto IMF monopoly on large-scale crisis lending? Or would the cost of any "deal" that would lead that countries like China and Russia and Saudi Arabia (which already has a large IMF quota) channel their lending through the IMF prohibitive?

The right answer isn't clear to me. On one hand, granting the new players significantly more votes might make it next to impossible to build consensus in the IMF - and even a generous increase in the voting weights of key emerging economies might not be enough to convince them to channel their "crisis" lending through the IMF. China might not want to give up on bilateral lending in exchange for say 15% of the IMF's voting shares. On the other hand, China hasn't been keen to throw its reserves around over the past few weeks - preferring the safety of Treasuries to Agencies (or a dollar deposit in Pakistan's central bank) - and might prefer conditional IMF lending to the risk of losing its funds ...

For now it seems to me that the crisis likely has increased the gap between the G-7 (and G-10) countries and the rest of the world in a couple of key ways. Inside G-7 land, US banks could lend in euros (and European banks lend in dollars) secure that they had access to a lender of last resort - and the G-7 countries would still be in a position to offer hard currency loans to their "out-of-area" friends through the IMF. Outside G-7 land, countries would rely primarily on their own foreign currency reserves to cover the foreign currency liabilities of their banks - and potentially could use their own reserves to finance their crisis lending to other troubled countries.**

In some ways, that is a world where the gap between the G-7 countries and the rest would gets larger not smaller ...

* Switzerland is an exception; it stands outside the 'Western' alliance but has access to the swap lines. But the Swiss have long been a big part of central bank cooperation - Basle and all.

** This leaves aside a key issue, namely the fact that countries outside the G-7 provide enormous quantities of unconditional dollar financing to the US through the buildup of their reserves. That reserve growth is partially a function of the need for countries outside the G-7 world of reciprocal swap lines to hold a lot more foreign currency - but it is also a function of these countries ongoing policy of pegging their currency to the dollar at an undervalued level. It also ignores the debate over whether sovereign funds investments in the US and European banks should be considered private investments for profit, or part of the global policy response to the crisis.

*** SWF Radar has been invaluable in tracking the use of sovereign funds to support domestic banking systems; many of my links are drawn from there.

John F. Mauldin

John Mauldin
Frontlinethoughts.com

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