Author: Andrew Sheng, Fung Global Institute
In October 2013, the US Federal Reserve decided to make permanent the dollar swap lines put in place during the global financial crisis with the Bank of Canada, Bank of England, European Central Bank, Bank of Japan, and Swiss National Bank. The swaps, totalling US$333 billion, basically enables the Fed to provide dollar liquidity in an emergency, essentially confirming that it is the only dollar provider of global liquidity.
But the dollar swap lines with the four non-G7 central banks — Brazil, Mexico, Singapore and South Korea (US$30 billion each) — were temporary facilities, which means that all emerging market economies (EMEs) will have to request swap facilities if they need them. Obvious candidates in the near future may include the Fragile Five — Brazil, India, Indonesia, South Africa and Turkey — who are also G20 members.
The Fed’s decision basically reinforces the view of the EMEs that they are essentially on their own in defending themselves against capital outflows and financial market volatility. The argument (advanced by Arvind Subramanian and Dani Rodrik) that they should accelerate structural reforms in response to the tapering of US quantitative easing monetary policy ignores the fact that simply ensuring sound economic fundamentals may not be a panacea against markets overshooting in times of panic. Structural reforms take time and in the interim a global flight of capital back to advanced markets could cause huge disruptions to EMEs, which will feed back negatively to the advanced markets.
The Asian financial crisis revealed to East Asians, most of which considered themselves hitherto in the ‘dollar zone’, that the US Fed would not be their lender of last resort, and that the IMF could not function also in that role. Subsequently, almost all East Asian economies built up sizeable reserves as self-insurance policies against future shocks. Despite being criticised for holding ‘excessive’ and ‘unproductive’ reserves, and accused of creating a ‘global savings glut’, they understood that when the tsunamis come, all were on their own. This remains a core problem for the international monetary architecture.
The other positive outcome of the Asian crisis was the creation in May 2000 of the Chiang Mai Initiative, a network of bilateral swap arrangements (BSAs) among the ASEAN+3 (ASEAN plus China, Japan and South Korea) countries to serve as a regional safety net mechanism to complement the IMF. In May 2012, ASEAN+3 agreed to double the size of the CMI to US$240 billion and replace and streamline the existing BSAs with a single agreement, the Chiang Mai Initiative-Multilateralisation. Despite earlier international concerns about moral hazard, the swap lines have never been activated, even during the global financial crisis.
People tend to forget that the Chiang Mai swap facility arose out of the first ASEAN central bank swap lines instituted in 1979 to help facilitate intra-ASEAN trade. There is increasing awareness that the central bank swaps should be operationalised to facilitate trade finance. Specifically, central bank swap lines can promote trade settlements in local currencies, including RMB, reduce foreign exchange risk and transaction costs, and can help backstop trade finance during crises. The aim is to prevent a recurrence of the Lehman moment, when global USD liquidity and trade finance dried up and triggered a 12 per cent collapse in world trade and a 1 per cent decline in world GDP in 2009.
Given the US reluctance to expand its dollar swap lines beyond a privileged few, and the IMF’s pre-occupation with Europe, emerging markets may need to create their own swap lines to provide a lifeline for crisis prevention amid dollar imperialism.
Since central bank balance sheets today account for nearly 8 per cent of global financial assets, central bank swaps and market interventions have become an important anchor of the global financial architecture. Central bank to central bank swaps incur sovereign credit risk, but provide liquidity to the recipient central bank that helps global liquidity and prevents financial sector failure arising from shortage of USD or reserve currency liquidity. Such bank swaps provide lender of last resort liquidity in reserve currency terms and is mutually beneficial.
The IMF no longer has a lender of last resort function. Its capacity to provide liquidity to member countries was always limited to the size of IMF quotas, and was further limited due to the US Congress’ unwillingness to increase the quota allocations. Since IMF loans are also subject to conditionality, which can take months to negotiate, the only remaining institutions that are able to inject quick liquidity on a global scale are the reserve currency central banks through their swap windows.
The time will come when the US economy shrinks its current account deficit and decreases dollar liquidity, creating a debt-deflation trap for the emerging world. If the leading central banks do not step up to provide compensating liquidity for the rest of the world, which is still growing faster than the advanced countries, then there will be a credit crunch.
Emerging market liquidity therefore hinges not only on China being a major commodity consumer, and in future a consumer of final products, but also the willingness of the People’s Bank of China (PBOC) to provide liquidity in terms of central bank swaps. This arrangement is different from the US model, whereby US banks provided liquidity through loans or floating bonds of EME sovereign governments.
Since June 2010, the PBOC has signed over US$426 billion worth of bilateral currency swaps with 21 central banks worldwide. It should be noted that the PBOC’s bilateral RMB swap line is already larger than the Fed’s swap lines with the Select Five of US$333 billion. RMB internationalisation through trade facilitation is a natural extension of the path for RMB to go global, in the same way that Japan paved the way for Yen internationalisation through lending and providing aid in Yen in the 1990s.
These developments underline the importance of the BRICS Bank in the evolution of international monetary arrangements. Most Western analysts see the Bank as a long-term development finance institution. But in practice it will become an important forum in which EMEs discuss amongst themselves how to improve the international monetary system, in the absence of reserve country economies willing to change the status quo.
In this way, currencies will serve the real economy, not the other way around.
Andrew Sheng is Distinguished Fellow of the Fung Global Institute, a Hong Kong-based think tank.