Podcast

Important Information:
Keeping Dollars Flowing Around the Globe
Important Information:
Ricardo Reis discusses how swap lines have supported the flow of U.S. currency into global financial markets to meet their liquidity needs and the dollar's prominence in those markets, especially during the 2007-08 financial crisis and the COVID-19 pandemic. Reis is an economics professor at the London School of Economics and a long-term consultant at the Federal Reserve Bank of Richmond.
Transcript
Tim Sablik: My guest today is Ricardo Reis. Ricardo is the A.W. Phillips Professor of Economics at the London School of Economics and a long term consultant of the Richmond Fed's Research department. Ricardo, welcome to the show.
Ricardo Reis: Thank you for having me. It's a pleasure to be here.
Sablik: You've researched and written extensively on monetary and fiscal policy topics. Today, we're going to be talking about one facet of monetary policy, which is central bank swap lines.
Listeners looking for a primer on this topic can check out my colleague Matt Wells' recent article on swap lines in our Econ Focus magazine. Matt talked with you, Ricardo, for that piece, so I'm very excited that you're able to join us here to discuss it on the podcast today.
I think a good place to start is, could you tell us what are swap lines between central banks?
Reis: As the name indicates, a swap line is nothing but a loan of, say, dollars by the U.S. Federal Reserve System to a foreign central bank, let's say the Bank of England. The Bank of England gives the Fed some pounds back — think about it as collateral for the loan. As the Bank of England returns the dollars, the pounds get returned also to the Bank of England from the Fed. So, it's essentially a loan of real money like liquidity [or] digital money from one central bank to the other.
The reason why the Fed would lend dollars to the Bank of England is so that the Bank of England can then lend dollars to U.K.-based banks. U.K. banks then pay you back, usually a week later.
Sablik: That naturally raises the next question, which is why would non-U.S. banks — say, banks in the U.K. — need access to foreign currency, particularly the dollar?
Reis: One important function of a central bank is to serve in what is known as a lender of last resort. What does that mean?
Banks at any point in time are going to be making payments, taking on deposits, making loans. Sometimes more people withdraw their money from their checking accounts — or the bank has lots of good ways in which to lend money for people to build houses or buy companies or others — than the money is coming in from that bank. And so, that bank has to go and borrow money for a few hours, sometimes a few days. Well, if one bank needs liquidity, as it's often called, there's often another bank that's willing to give it that liquidity. Therefore, you'll have banks borrow from each other. That is what some listeners may have heard called the federal funds market.
However, because there's such large amounts going from one bank to the next, sometimes one bank just can't find another bank to lend it the money so it can honor its depositors. At that point, it's important that banks are able to go to the central bank and be able to borrow that money so they can keep their commitments to their depositors.
Now, the central bank is going to be really tough on the banks in terms of charging them a pretty high interest rate, requiring a lot of collateral to make sure this is very safe. After all, the banks should have really been managing their money better, but stuff happens sometimes. In the same way that we have insurance as the last resort to when, even though I drive my car carefully, sometimes stuff happens, so do banks have the central bank. This is crucial, Tim, for the banking sector to operate, as opposed to having a crisis every other week or every other month.
What happens when you start having a very globalized financial market where the dollar is absolutely central? The dollar is very used outside of the U.S. to make loans, to collect payments. What happens is that you're going to have a lot of British banks, continuing with our example with the U.K., that are borrowing dollars, often making payments in dollars, accepting deposits in dollars. These banks are not regulated by the Federal Reserve System, so the [Fed] is not willing to just lend to them when they show up and say, I really need a few million dollars tonight. It's not feasible for the Federal Reserve System to keep an eye on these banks and to know if the guys showing up are reputable and they're borrowing for good reasons.
Instead, these banks are regulated by the Bank of England. The Bank of England, therefore, should take on the risk of lending to these banks. However, when they want to borrow not pounds but dollars, the Bank of England does not have the dollars. This is where the swap lines come, where the Bank of England takes on all the risk, all the supervision, all the collecting, all the decisions on whether to lend or not and the Fed, essentially, all it does is provide the dollars.
Sablik: You mentioned how sometimes banks might not be able to get liquidity from other banks in a crisis. Is there a similar reason why non-U.S. banks might struggle to obtain dollars from the private foreign exchange market in a crisis?
Reis: The U.S. is so central in the international financial system. For instance, many people in the podcast probably deposit money in U.S. money market funds. A lot of what those money market funds do with all of that money is lend to foreign banks. Why are they borrowing? Often, they're borrowing because they want to buy U.S. corporate bonds.
The reason why the swap lines really have been activated twice — in the 2008-09 period and then for a few months during COVID — is that the U.S. money market funds contracted in terms of their willingness to lend outside because we had so many problems. The international markets and the different foreign banks were also, during COVID, very afraid of extending new loans. Therefore, you started having a lot of cracks in the system where a lot of banks that usually would, on a daily basis, just go and borrow and lend — that's what banks do — could not find that funding. Then it turned out that several banks needed to show up for a lender of last resort, which, again, on a usual day they never do because it's very expensive. But they had to in these two places in time. It was very important that the Bank of England, ECB [European Central Bank], and all the other foreign central banks were able to do that.
What if they hadn't? It's not just that these U.K. banks would have gone bust. What they would have had to do is unwind their U.S. positions. They would have to sell all those U.S. assets that they've been buying with those borrowed dollars. We would have had a big, big crash potentially in a series of U.S. markets.
Sablik: You mentioned the Fed used these swap lines during COVID and then during the financial crisis. Maybe we can dig into that history a little bit more. How did swap lines emerge as the solution to this problem?
Reis: Swap lines had a long history. They were very used in the 1960s and 70s for a very different purpose.
At the time, we had the so-called Bretton Woods exchange rate arrangement system. Different countries — Peru, the UK — would have their exchange rate — the value of the pound — pegged to the dollar. What that meant is that they often had to buy and sell dollars to make sure the value of the pound to the dollar was there. Swap lines existed then insofar as sometimes [countries] needed to borrow dollars to buy pounds and push up the value of the pound.
Swap lines then pretty much disappeared throughout the '70s, starting with the demise of Bretton Woods in the early 1970s. When the U.S. government abandoned that system, there was no longer any need.
Then, in 2000, some may remember the Y2K problem. There was this big fear around the turn of the millennium that banking systems would collapse and they may not be able to come up with money. At that point, there was this very small swap line signed under the entrepreneurship of the governor of the Bank of England who said, let's sign a swap line so that if on January 1 of 2000 there is some problem, at least we make sure that our UK banks — a lot of the business of the rest of the world and international markets goes through London — they would at least have the dollars. It was perceived to be a very small thing. It was never used, never activated.
In 2007, when we had U.S. money markets all withdrawing all their investments, as we're having a freezing of banks not wanting to lend to banks all over the world because they didn't know which bank was safe and wasn't, it became extremely important when the Fed announced the swap lines. You had immediately very large volumes, many from the U.K., of borrowing these dollars for a few months. That was absolutely fundamental for us not to have a market meltdown in 2007 and 2008.
I think we understood from that experience one important comparison, which was between the Fed and the ECB. The ECB did not create European swap lines right away. Lo and behold, Tim, because the Fed was very good at creating the swap lines and the ECB was not — it took them a couple of years to get their act together — the euro fell from being 12 percent of payments to being 8 percent of payments. It's never recovered. Why? Because I know that if I make payments in dollars, the Fed is going to make sure that the system keeps going. The ECB lost a little bit of that trust in international markets, and these things are very sticky.
Things were like that, then COVID came and, as I told you, there the concern was the ability for foreign banks to buy all those Treasuries [and] lend to the U.S. One, the Fed extended the swap lines because it only signs them with a very small, limited number of countries. It extended it to include Australia, New Zealand and a few others, Canada as well. Two, it created a very complimentary program, the FIMA [Foreign and International Monetary Authorities] program, which is for all purposes very similar. Instead of the foreign central bank giving you the foreign currency, they can place U.S. Treasuries as the collateral.
Sablik: Thanks for that history.
It seems swap lines are clearly beneficial to foreign banks and businesses through foreign central banks. Do they also provide benefits to the U.S. economy?
Reis: Number one, it prevents fire sales of U.S. assets during crisis times that would push down U.S. markets throughout.
Number two, for the Treasury market, it is especially important in stabilizing gyrations in the interest rate at which the U.S. government borrows and making sure that that steady stream of funding to the U.S. government continues. A lot of foreign banks lend to the U.S. government, buy U.S. Treasury bonds issued by the Treasury Department.
The Treasury Department, during COVID, was borrowing a lot to help people, to send checks out. It was very important that we were able to keep on borrowing from those foreign banks. And yet, those foreign banks were having a lot of trouble with finding some of their funding in dollars. For that, the swap lines were very important as that backstop for a few days where problems emerged.
Number three, swap lines give trust and faith in foreigners using U.S. dollar to invoice, to make payments, to make short-term loans. They know that, at a very large cost and in very rare circumstances, they can count on being able to borrow dollars short term and, therefore, not just go bust and be unable to honor their commitments.
Sablik: Yeah, so it helps shore up the dollar's position in the international markets.
Reis: Exactly.
Sablik: It seems that central banks see the value in having these swap line arrangements. But are there any potential risks or costs that central banks should be also thinking about?
Reis: For the Federal Reserve, the way it's set up its swap lines, the risks or costs are really, really very small. There's no direct cost, per se, in the sense no money gets lost in any of these transactions. The risk is essentially that the Bank of England doesn't pay back.
Of course, the Fed still has a bunch of pounds. Maybe those pounds are not worth as much as when you lent the dollars. Imagine there is a complete collapse of the UK and the pounds lose a lot of value. The Fed could ask for what is known as a haircut — that is, ask for more pounds than the dollars it lends — and, therefore, to a very large extent insure against that.
Even without a haircut, the circumstances in which the Bank of England would not pay back the Fed are absolutely extreme. In the worst case scenario, the Bank of England can always print pounds, buy dollars in the market, and pay back the Fed. So, it would really take a geopolitical collapse of trust for the Bank of England not to pay.
That explains also, in great part, why the Fed only has [swap lines] with the ECB, Bank of Japan, Bank of England, Swiss National Bank. These are friendly countries. It seems to me unimaginable that they wouldn't pay back the Fed.
However, imagine the Fed decided to do what the PBOC [the Central Bank of the People's Republic of China] has done, what the Chinese authorities have done — start expanding [swap lines] to many, many other countries. Then, these questions of default, collateral, [and] haircuts would come up.
The PBOC has taken increasing risks. They have had recently cases of non-repayment when a country was in fairly bad shape. In the end, they repaid.
The Fed has stayed away from this. It has been extremely conservative. What that has meant is that the Chinese coverage is much wider than the American one, even if the dollar is dominant. The renminbi is starting to be increasingly used in Africa, the Middle East, and Latin America. Well, the swap lines have contributed to that.
The renminbi has been gaining a little bit of ground relative to the U.S. — to be clear, very little ground. The renminbi has gone from being zero to being, depending on the measure, two to five percent of payments. The U.S. dollar may have lost one or percent of those, with the other two or three percent being lost by the yen, the euro and others. So, we're not talking about a competition — the dollar is still dominant.
Sablik: So, there's this tension between how you address these risks [and] who you extend these swap lines to.
Are there any unanswered questions or open questions about swap lines that you're hoping to explore in future research?
Reis: I think there's three big questions that I raise.
One is the interconnection between the swap lines of different central banks. I'm a bank in a country that doesn't have a swap line with the U.S. but I need dollars. Well, what if I go and borrow renminbi from the central bank of China and exchange those for dollars in the market? At the same time, the Chinese central bank lends renminbi by borrowing euros from the ECB because there's a swap line between the two of them. In turn, the ECB gets dollars for the euros by using the swap line with the Fed.
On the one hand, this is certainly a contorted story and it would never happen in these direct ways. But across markets, you can see these flows going, with a very large demand for dollars starting in South Africa and somehow spread via the ECB as intermediaries towards the Fed. Boy, you then really start asking questions about what if one of these chains in the network fail. So, understanding this interconnection and the global scope is an important question.
A second question is when the dollar gets more used internationally, how much does the U.S. versus the other countries benefit? While we speak about the dollar dominance, sometimes with a little bit of national pride, there's an open question about how much does one really benefit. You gain some political power, but in economics are you losing some for that? Are you winning?
Third, as we get experience of these loans happening and being repaid, there's a lot of open questions on how to design better contracts. At the end, [swap lines] are contracts with conditions on who pays what and when, with what collateral [and at what] interest rates. I think there's a lot of work to be done there.
Sablik: Yeah, a lot of interesting stuff to keep watching. We'll have to have you back on the show again to talk about some of those.
This is going to do it for today. Ricardo, thanks so much for joining me.