As global markets fell into dire straits in March, off the back of fears around Covid-19, the Fed decided to roll out its programme of swap lines to some other central banks. Many believe this intervention, inspired by Fed swap line extensions in preceding crises, stifled a serious market sell-off and softened a global dollar shortage.
Swap lines like these were first used at the cusp of the financial crisis in 2007 and throughout the subsequent global fallout, and during the eurozone debt crisis in 2010 and 2011. They are seen as an effective method of stabilising economies and foreign dollar markets. The US central bank lends dollars to other central banks for their local currencies for a fixed period, swapping back the currencies when the loan matures with a level of interest.
The Fed lent out hundreds of billions dollars in the first few months of the Covid-19 crisis through swap lines, and launched a programme that allowed 170 central banks to borrow dollars against their holdings of US Treasuries.
In early June, Andrew Hauser, executive director of markets at the Bank of England, said in a speech that swap lines “may be the most important part of the international financial stability safety net that few have ever heard of”.
Setser told GlobalCapital he was surprised by the speed and forcefulness that the Fed deployed swap lines, but that greater coordination will be needed between central banks and supervisors if they are used in future crises.
An alumnus of Harvard and Oxford, Setser was an economist at the US Treasury and director of global research at economist Nouriel Roubini’s Roubini Global Economics Monitor (Roubini Global Economics is now called Continuum Economics). Setser co-authored a book with Roubini, whose bearish forecasts earned him the nickname “Dr Doom”, entitled Bailouts or Bail-ins?.
Setser is now the Steven A Tananbaum senior fellow for international economics at the Council on Foreign Relations, where he runs the renowned economics blog Follow the Money.
GlobalCapital: A lot has been made of swap lines, in some circles, and the importance of them throughout this pandemic, as well as preceding crises. In your judgement, just how significant were they in protecting the global economy during this crisis?
Brad Setser: It’s a little bit hard to say swap lines were the most stabilising action, given the fact that the Fed’s enormous purchases of US Treasuries were obviously at the core of its overall response.
Without the actions to directly stabilise the US Treasury market, then the actions to stabilise various markets from bank funding, including funding for global institutions, provided by the swap lines, probably wouldn’t have worked.
But there’s no doubt that the liquidity provided, particularly in East Asia, through the swap lines played an important role in stabilising dollar funding markets.
There’s actually evidence from a paper produced by the Bank of International Settlements that this stabilisation in the swap market even helped stabilise domestic US dollar funding markets, because European banks could take advantage of the dollar swap lines and participate in the commercial paper market and domestic US funding markets in a way that they weren’t able to before.
GlobalCapital: In some articles, you could get the impression that extending swap lines was some sort of altruistic action from the Fed, that by acting as a default lender of last resort showed the institution had a heart. Call me a sceptic, but presumably there’s a stronger case for economic self-interest.
I think the balance is much more weighted towards US self-interest. Swap lines are a recognition that European, Japanese and Korean institutions borrow dollars in global funding markets that they in turn use to play an important role in financing the US economy.
Before the global financial crisis, most of the dollar funding need came from European banks buying asset backed securities. Some of the funding they needed came from central banks placing their foreign exchange reserves in European banks, some came from US money markets, but some came from European banks swapping euros for dollars. That is how they were able to carry a large portfolio of US asset-backed securities on their balance sheet.
What’s changed over the past 10 years is the European dollar funding need has fallen, and that shows in the relative use of swap lines this time compared to last.
At the same time, the relative importance of dollar funding in much of Asia and particularly Japan has increased. In the run up to the Covid-19 crisis, a number of Japanese institutions were big buyers of dollar corporate credit, whether that was in the CLO market, or longer dated, typically investment grade, US corporate bonds bought by the lifers [life insurance companies]. In both instances, the Japanese institutions were largely buying on a hedged basis, so they relied on steady access to dollar funding markets and particularly cross-currency funding markets.
Think of it as Japanese financial institutions running shadow US banks, but because they were running shadow US banks they were part of a financial ecosystem that was providing financing to the US economy.
By stabilising global dollar funding, the Fed was helping stabilise access to credit by US companies, and in that sense it is in no way altruistic.
Of course, there are uses of the dollar globally that don’t touch the US, like trade finance and alike. So by providing dollar swap lines to a number of countries, the US helps support the provision of trade financing globally using the dollar. And I think that leans a little bit more towards altruism.
But even there it’s not in the US’s interest for global trade financing markets to dry up. Nor is it in the interest of the US for folks to conclude that it isn’t able or willing to be a lender of last resort.
GlobalCapital: The implementation of swap lines through this crisis seemed much more prepared and deliberate than previous extensions. Are you comfortable with the idea that the Fed is considered the global lender of last resort? Are there broader implications to this?
Well, I think your initial observation is correct. Swap lines were a tool that was, by this stage, well understood, and relatively easy to use in a technical sense. The Fed allowed access to broadly the same set of countries that received them in 2008.
It just so happened that the bulk of the dollar funding needed was concentrated amongst those countries. As I mentioned earlier, the distribution did change, and Korea and Japan in particular were much heavier users of the swap lines this time around than the last.
I think that does highlight one implication of this. To the extent the US is worried the provision of dollar financing encourages excessive risk taking by levered entities, in dollars in this case, then the US has to look not just at leverage and risk taking amongst US financial institutions, but leverage and risk taking undertaken in dollars globally.
Equally, those supervisors in Asia that allow these large dollar funds to build up may need to reconsider some of their regulatory policies. The Fed has shown that it is willing to do act as a dollar lender of last resort globally and I think it will continue to be willing to do this, but you want to be cautious and careful that the availability of the dollar lender of last resort doesn’t encourage imprudent risk taking forward. I think there is a little bit of a risk of that in Asia.
The other broader lesson here is that preparation matters.
There is an argument that Korea and Taiwan did a better job of responding to Covid-19 because of their experience with Sars.
Similarly, you can make a strong case that the Federal Reserve was better able to manage the financial stresses emerging from Covid-19, because of its experience with the global financial crisis and its ongoing effort to understand how best to use the tools that were pioneered during the global crisis.
GlobalCapital: The Fed fared better in this crisis because of the lessons learned and tools better understood from the last financial crisis.
The Fed had a well understood playbook for how to provide dollar liquidity globally through swap lines. It was much more comfortable using asset purchases on a larger scale than ever before. So, very large treasury bond purchases were undertaken more rapidly than in the past, and more generally the Fed, and other central banks as well, were better prepared to use policy tools other than short-term interest rate cuts.
But I think the Fed would be the first to admit that they were surprised by the magnitude of the stress that emerged in March, especially in the US Treasury market. And they were probably a bit surprised by the magnitude of the dollar funding need in Japan.
So even if the Fed did have some blind spots going into the crisis, it was ready to use the full force of its balance sheet quickly. I think that played a decisive role in March and April. Obviously you can contrast the Fed’s strength in clarity in those months with the much more confused fiscal response we’re seeing now in the US.
GlobalCapital: Almost my first question after I dug into swap lines, was how on Earth has this not become politicised? The isolationist strain on the political right and left runs deep across the US — how has neither latched onto this expansion of power?
The technical nature of the swap lines, and the fact that they pose almost no risk to US taxpayers, is significant. A swap line is an extension of dollars to the [European Central Bank], the Bank of Japan, the Bank of England and the Bank of Korea — some of the most credible counterparties around the world. The actual risk taken by US taxpayers is much smaller than the risk taken in other Fed operations. It is a pretty obvious extension of the Fed’s role as domestic lender of last resort. And it doesn’t push the Fed into any real new territories.
So I think that is important when explaining why swap lines haven’t been politicised. The fact that Trump was criticising the Fed for doing too little going into the global financial crisis may have helped. It’s hard to criticise the Fed for doing too much when you previously have been saying, you know, ‘Jay Powell — where are you?’ ‘Jay, why is my cost of borrowing up so much?’
It’s probably a little bit too technical for [president Donald Trump], but it’s not hard to explain to [US treasury secretary] Steve Mnuchin that if you want cheap corporate credit in the US, you need to keep dollar funding available for Japanese financial institutions.
GlobalCapital: There's a clear economic case for swap lines and the extension of swap swap lines across the world, but Washington is often, and perhaps quite rightly, consumed by things beyond economics. Even if the Fed is extending swap lines to the most credible institutions across the world, that is still something that may rile at least portions of the electorate that don’t see that as the US’s responsibility.
You could say it is a puzzle. You can say it’s a function of the broad political system not understanding that the US has backstopped the global financial system to the tune of $0.5tr. You can say it’s a function of the fact that this looks small compared to the Fed’s intervention in the US Treasury market.
But it is an unquestioned legal authority of the Fed — there’s no real debate about whether the Fed has the legal capacity to do this. It is something that the Fed, operating within its mandate as an independent institution, has done in the past.
So in that sense, it has stayed outside of politics for now, because the political system hasn’t been asked to reach a judgement on a tool that is a long-standing part of central banking. So the fact that the Fed can do this without taking real credit risk, using established legal authority has meant that it hasn’t become a political football.
GlobalCapital: This has clearly been an effective tool for the Fed and by necessity therefore the global economy. Is it set to remain as such? Is there any downside or risk of diminishing returns?
Well there’s the classic problem of providing a lender of last resort, which also can lead to bigger balance sheets and more risk taking. In this case, there’s the risk that it accelerates the growth in the offshore dollar market in ways that are challenging.
And thus the more you use it, the more you need to use it in the future, because you have a set of financial institutions operating strategies that fundamentally assume continuous access to short term funding.
To some degree you have already seen that. After the global financial crisis the regulators did worry that the European institutions were too dependent on currency swaps, and other short term forms of US dollar funding. But regulators in Asia allowed their institutions to take on more dollar funding risk.
Swaps are complicated, but basically if you have yen, for example, it’s a way of getting dollars. If you’re doing a three month swap you’re getting dollars for three months at a three month rate. And then a lot of institutions were using that tool to finance their 20 year or 10 year US investment grade credit portfolios.
Does that pose a risk? Well, it certainly poses some risks to those financial institutions. If big enough, it poses a risk to the US economy if they don’t have access to continuous dollar funding markets. So you do have to worry that too many institutions, not just banks but also non-banks, will become dependent on the expectation of access to dollar liquidity through the swap markets.
That’s a regulatory challenge, and it is a complicated regulatory challenge. It’s one where the regulators of the institutions that use dollar financing are not American. There are Japanese, European, Korean and Taiwanese supervisors, including supervisors of insurance companies supervising institutions that are playing a big role in US dollar corporate credit markets, and, in the past, US dollar asset backed securities market.
It does call for some increased coordination. The Fed can always try to limit risk taking in not just the amount that it provides, but the price it offers it at. One feature of Covid-19 is that it was such an obvious exogenous shock that you didn’t want to penalise institutions with high costs.
There’s a set of risks to be considered but at the end of the day, if the dollar is going to be used globally, and banks are going to be banks, and there’s a set of non-banks, like lifers, which are going to run strategies that fundamentally are based on the yield curve and are assuming continuous access to rolling hedges — which looks a lot like rolling three month deposits — then you’re going to need to have a global dollar lender of last resort. And if the Fed isn’t willing to provide it, that means their own home countries with large stockpiles of reserves would end up likely being suppliers. That would pose a different set of risks.
That’s another strange way in which this helped stabilise US markets. Japan sits on $1.2tr of reserves. It could have met the dollar funding need of its financial institutions, which was around $200bn at its peak, by selling some of its reserve assets to sell US Treasuries and lending the dollar cash.
But had it done so, this would have added to the pressures on the US Treasury market at a point when it was already under stress by the unwinding of the relative value trades and by capital flight from emerging economies. So by supporting the dollar balance sheet of these institutions around the world, the Fed actually helped take pressure off the US Treasury market by making it possible for countries like Japan, Korea, Singapore and Mexico to have a dollar lender of last resort, without selling their reserve assets.
GlobalCapital: If you charted the trajectory of the Fed’s response to the coronavirus, was it relatively similar to what you would have predicted?
It was with more speed, more force and with fewer half-measures than I probably would have expected. The Fed realised, very quickly in March, that they needed to get ahead of building pressures, particularly after the horrible week in the middle of March when the US Treasury market came close to collapsing.
The Fed didn’t start small and expand. It moved quickly and boldly.
The actions the Fed took were in some sense a direct evolution of the toolkit that emerged out of the global financial crisis. But the toolkit that emerged out of that was created in the global financial crisis that emerged over a year and a half, and, in this instance, which was a different type of shock with different magnitudes, these tools were rolled out within a two to three week period.
And so I give a lot of credit for the Fed taking action so quickly, for recognising the magnitude of the shock and responding with programmes that were commensurate with a shock of unprecedented size.
The current Fed leadership owes a debt of gratitude to the Fed leadership during the global financial crisis, which had to pioneer a lot of these things. But the current leadership deserves enormous credit for recognising the magnitude of this shock and acting so swiftly.