Since the 2007 financial crisis, central banks have used swaps to raise foreign currency, increase reserves, and lend to domestic banks and companies. Although the terms of the swap arrangements are intended to protect the two central banks involved in the swap against losses due to currency fluctuations, there is some risk that a central bank will refuse or be unable to comply with the terms of the agreement. For this reason, lending through currency exchanges is an important sign of trust between governments. But it can also be a sensitive domestic issue; Lawmakers in the United States and even public commentators in China have expressed concern about the risk their respective central banks are taking by extending swap lines to certain countries. In October 2008, then-New York Fed President Timothy Geithner noted that Europe is “operating a banking system that has been allowed to become very, very large relative to GDP, with huge monetary inconsistencies and no plan to meet the liquidity needs of their dollar banks in case we face a storm like this.” While swap lines have prevented asset sales and other measures that would have exacerbated the crisis, the fact that swap lines now appear permanent could actually encourage these “huge currency mismatches” to grow. Banks will now expect their central banks to provide them with foreign currency when market pressures again make it difficult to obtain this financing in private markets, and those who lend to foreign banks will continue to do so in the hope that they will be repaid in the event of a crisis with central bank funds. The existence of swaps therefore makes all the more important the restrictions on banks` dependence on short-term refinancing and the requirement for foreign banks to have high-quality liquid assets in local currency. In addition, since 1994, the Federal Reserve has entered into bilateral currency exchange agreements with the Bank of Canada and the Bank of Mexico under the North American Framework Agreement (NAAA). When a foreign central bank uses its swap line to fund its bidding operations in dollars, it pays interest to the Federal Reserve equal to the interest the foreign central bank earns on its bidding operations. The Federal Reserve holds the foreign currency it acquires from the foreign central bank under the swap arrangement (rather than lending or investing in private markets) and does not pay interest. The structure of the agreement serves to avoid difficulties in managing domestic foreign exchange reserves for foreign central banks, which could happen if the Federal Reserve actively invests foreign currency holdings in the market. [9] Rose, A and M Spiegel (2012), “Dollar illiquidity and central bank swap arrangements during the global financial crisis,” Journal of International Economics 88(2): 326-340.
With regard to the factors that led to the selection of the same nine central banks to obtain swap liquidity lines, we note that access to liquidity arrangements is determined by the recipient countries` close trade relations with the United States. This contrasts with the previous episode of dollar shortages in 2008, when the Us signed swap agreements with emerging markets due to its financial relationship with the US (Aizenman and Pasricha 2010). The existence of formal military alliances has also been a key determinant for the Fed to reactivate trade for these economies. On 12 December 2007, the Federal Reserve extended swap lines to the European Central Bank (ECB) and the Swiss National Bank (SNB). Demand for dollars from European banks has skyrocketed, leading to increased volatility in US dollar interest rates. The swap lines were intended to “counter increased pressures on short-term funding markets” without the Fed having to directly fund foreign banks. Although the number of economies that have entered into swap agreements with the United States is limited (i.e. a total of 14 with five central banks that have concluded long-term agreements and nine reactivated), the newly created FIMA facility is available to economies that do not have swap agreements as long as they hold holding holdings of US Treasury bonds in their foreign exchange reserves, which they can exchange for dollars in reverse repurchase transactions. Therefore, the sum of the maximum amount of the swap arrangement with the Fed and the amount of U.S.
Treasuries in an economy`s foreign exchange reserves can be considered the potential availability of Fed liquidity lines. Under this assumption, we find that the increased exposure of U.S. banks and commercial banks to an economy has increased their access to dollar liquidity lines. Access to dollar liquidity also reflected global trade risk, whether or not a country no longer has financial or trade relations with the United States. Just as the Fed faced internal criticism for “bailing out” European banks during the financial crisis, the PBoC was publicly reprimanded for signing a swap deal with Russia shortly before the ruble`s depreciation in late 2014. The PBoC was forced to respond via Chinese social media, stating that swaps are guaranteed based on the exchange rate in effect at the time of their actual use, rather than the old interest rates that prevail at the time the agreements were signed. Previous fluctuations in the value of the ruble were therefore irrelevant – the bank was indeed well protected. But the controversy has shown how sensitive the swap issue has become in an era of global financial turbulence.
The ECB initially agreed to provide euros to Hungary, Latvia and Poland only through repurchase agreements, where bonds are held as collateral rather than currencies, but eventually extended a normal swap line to Hungary. Switzerland also provided Poland and Hungary with Swiss francs in exchange for euros. Many households in Poland and Hungary had taken out mortgages denominated in foreign currencies because interest rates on these loans were lower. Demand for Swiss francs and euros from the Hungarian and Polish banks that issued the loans drove up the cost of borrowing in these currencies; swap lines are expected to ease the upward pressure exerted by this demand on euro and Swiss franc interest rates. . . .