International financial stability has not been seriously tested by the COVID-19 pandemic, but this may be about to change as advanced economies recover with a growing risk of sharp divergence between their economic performances and those of most middle- and low-income countries.
Since the global financial crisis a decade ago, the international community has worked to strengthen the global financial safety net. The current system has four key elements – the International Monetary Fund (IMF), multilateral regional financial arrangements (RFAs), national foreign exchange reserves, and bilateral central bank swaps. But each has its drawbacks for users of the wider international system.
The G20 decision in April 2020 to increase IMF resources by $650 billion boosted its ability to respond to pandemic-related shocks and at the start of August 2021 the IMF Governing Board announced an allocation of $650 billion of SDR (Special Drawing Rights), the IMF’s liquidity instrument. But countries accessing IMF resources face a loss of sovereignty because of the conditions which must be agreed and the monitoring while arrangements are in place.
The stigma is so great that even the Flexible Credit Line, which is granted on pre-existing creditworthiness rather than new conditions, has only been used by five countries – Mexico, Peru, Poland, Chile, and Colombia. SDR are allocated according to IMF quotas, so most of the allocation goes to richer countries in the first instance, which may not be where SDR are needed most.
Under RFAs among emerging market economies, such as the Chiang Mai Initiative in Asia and the Latin American FLAR, countries agree to offer credits to partners in difficulty. This does avoid the perceived stigma linked to borrowing from the IMF but is only effective if the shock does not affect all partners simultaneously. RFAs also carry a risk of moral hazard because in the absence of meaningful conditionality countries may claim support too frequently or the safety net may promote reckless economic policies.
National foreign exchange reserves can provide a buffer against all types of shock if accumulated by a country on sufficient scale. But if this tactic is used by many countries it can exacerbate global imbalances and tie up national resources in relatively poorly performing assets.
The US Federal Reserve revived the system of bilateral central bank swaps in response to the shock to dollar liquidity after the collapse of Lehman Brothers in 2008. The Fed offered to swap dollars in exchange for euros, Swiss francs, or sterling so that the central bank issuers of these currencies could in turn lend the dollars to banks in their jurisdictions thereby ensuring the global financial system continued to function.
As the global financial crisis unfolded, this network widened to include several other OECD central banks as well as selected emerging market economy central banks deemed to be systemically important or with major financial centres, such as Brazil, Mexico, South Korea, and Singapore.
The swaps were drawn on heavily for a short time, especially by the European Central Bank (ECB), and there was a renewed burst of drawing during the European sovereign debt crisis in 2010. Activity on the dollar swap lines then effectively ended for a period but, when the pandemic struck in March 2020, the mechanism was revived and made easier for central banks to access with the Bank of Japan becoming the largest user. But not all countries have access to this scheme.
Alongside bilateral Fed dollar swaps, the ECB, Bank of Japan, Bank of England, Bank of Canada, and Swiss National Bank have also developed bilateral swaps with each other ensuring the availability of liquidity among these central banks in any of the partner currencies. These arrangements have remained on the books since 2013.
The role of the BIS in central bank swaps
Although widely hailed as an important new initiative supporting global dollar liquidity during times of acute uncertainty, the Federal Reserve swaps of 2008 actually have a longer history dating back to the early 1960s. Back then, swaps with other central banks were typically used to provide foreign exchange to stabilize currencies during the pegged exchange rate era of Bretton Woods.
However, the second largest Federal Reserve swap was with the Bank for International Settlements (BIS) not with a national central bank, and this was uniquely used to manage offshore dollar liquidity rather than exchange rates – a purpose similar to the 2008-2021 swaps.
In the 1960s the BIS was at the hub of a broad international network of swap lines and other short-term credits. It acted as a principal on its own account in various short-term loans and swaps with its member central banks, and also provided a venue for central banks to plan cooperation and collected data in support.
After 2007 the BIS did not engage so directly in providing standing liquidity facilities through its operations with central bank members. But on April 27, 2021 the Bank of England (BoE) announced it had concluded an agreement with the BIS to provide short-term sterling liquidity to the BIS central bank customers if needed.
The announcement did not attract much public interest but it is an unusual arrangement which raises important questions about the future role of the BIS in the global financial safety net. Essentially the BoE agreed to supply sterling to the BIS so it could then lend it to other central banks ‘to ensure the provision of sterling liquidity during any future periods of market stress, complementing the BoE’s existing established network of standing bilateral swap lines’.
From the BoE’s perspective a key consideration in setting up the new arrangement is likely to have been what governor Andrew Bailey has described as the ‘dash for cash’. In just one week, from 12-20 March 2020, customers drew around ten per cent of their funds – £25 billion – out of sterling money market funds (MMFs) and, under this pressure, the MMFs began to run out of cash and started to draw funds out of banks.
To prevent the market freezing up, the BoE ‘turned the fire hoses on at full blast’ by buying massive amounts of gilts and extending the Contingent Term Repo Facility to lend reserves against a broad range of collateral. If such an event is ever repeated, the new arrangement with the BIS would give the BoE a further mechanism for injecting sterling liquidity indirectly into international financial markets.
This might be particularly helpful in relation to overseas banking markets where a direct lending relationship with the local central bank is potentially problematic – the BIS has some 140 central banks as its customers.
Meanwhile, from the BIS’s perspective, the new facility could be a step towards re-instating its historical importance as the ‘spider’ at the centre of a web of central bank cooperation – beginning with sterling but in time extending to other, more significant, international currencies.
It is still unclear how exactly the recent initiative by the Bank of England and Bank for International Settlements will play out. It may end up as a standalone initiative reflecting particular concerns of the Bank of England following Brexit, but it could be the start of a broader move to strengthen the global financial safety net by drawing on the BIS’s ability to intermediate between reserve currency suppliers and central banks around the world.