International organizations,
The Eminent Persons Group (EPG) identified as a key goal for the G20 to secure the benefits of interconnected financial markets and in particular to enable countries to utilize international capital flows without risks arising from excessive market volatility. That this goal remains an aspiration in 2019 despite the innovations introduced in the wake of the global financial crisis (GFC) is telling. FX liquidity lines are an important area where gaps persist.

When the GFC broke out, FX swap lines quickly emerged as a gap in the global safety net that we hitherto didn’t know existed—specifically, even countries without significant imbalances and reserve currency issuers could find themselves in urgent need of vast amounts of foreign cash, courtesy of their banks’ funding models. In the event, it was promptly remedied, with the US Federal Reserve (Fed) and then other major central banks quickly stepping in. Does this mean we can trust this gap will not reemerge in the next crisis? Far from it.

What worked in the GFC
Starting with the Fed, major central banks found themselves challenged in implementing their own monetary policies when both their banks and overseas ones suddenly found themselves exposed massive FX funding shortages. They saw it in their own immediate interest to act as intermediaries between the source currency central bank and their banks, whose soundness and creditworthiness they were better placed to assess. Thus, in late 2007 the Fed entered into swap lines with the ECB and the SNB and shortly after the collapse of Lehman Brothers in September 2008 with the BOJ, BOE, and a series of smaller development market central banks. Remarkably, these liquidity lines were uncapped, and swaps outstanding peaked at nearly $600 billion. Swap lines were also established between several of these other central banks. These were ostensibly monetary policy decisions, taken for domestic motives, without pressure from respective governments.

Many emerging markets faced similar needs, but ultimately only Brazil, Korea, Mexico and Singapore received Fed swap lines, after consultation with the US Treasury and State Department. These swaps were capped and gave the Fed tighter control of any drawings. But they ended up barely drawn and still succeeded in stabilizing dollar funding costs not just for the four recipient emerging markets but also more generally. In Europe, the ECB limited itself to repo lines with Hungary, Latvia and Poland—i.e., agreements whereby euro-liquidity would be provided against euro-denominated collateral—though the Riksbank through its swap lines with Latvia and Lithuania further contributed to providing EUR liquidity where it was needed. Again, in all these cases, the prime motivation was seen as domestic national interest, specifically financial stability and monetary policy transmission.

Next time will be different
Following the GFC, regulatory changes have forced banks to become much more prudent in managing liquidity needs in general, including their FX exposures. As a result, the potential FX liquidity needs arising from banks are generally much lower than in 2007. However, they have not disappeared. The European Banking Authority recently reported that a large number of EU banks had US dollar liquidity coverage ratios well below 100%, and many of them close to 0%. More generally, at 14% of GDP, international lending in US dollars is now 50% larger than in 2007, and the bulk of that lending is now in the form of debt securities, not bank loans. In Latin America, the share of dollar debt in the form of debt securities reaches 12% of GDP. In Europe, emerging markets hold 9% of GDP worth of dollar-debt. If dollar markets shut down again as they did in 2007/08, there will likely be substantial FX liquidity gaps, and these will be more challenging to plug now that the counterparts needing liquidity will often not be banks. Meanwhile, euro funding needs generally remain much lower but there are a handful of banks in the non-Eurozone EU with euro liquidity coverage ratios below 50%.

Against that backdrop, the liquidity safety net has improved in some dimensions, but significant gaps, or at least question marks, remain. A key innovation since the GFC has been the multiplication of swap lines between the People’s Bank of China (PBOC) and thirty-some EM and DM counterparts around the globe. The network of swap lines among major DM central banks has become permanent. And the Chiang Mai Initiative bilateral swap agreements have been multi-lateralized and expanded. Furthermore, FX reserve holdings are up 70% globally since Q42007, with a dollar share of around USD 7 Trillion (62%). In other words, the global financial system is not short of dollar liquidity as a whole. But can the current set up guarantee that this liquidity will find its way promptly to where it is needed in a crisis? That seems likely among DM actors, but much less so for EM. The criteria used by the Federal Reserve, the ECB, and others to extend swaps to certain EM and deny them to others were never made explicit—although sound macroeconomic fundamentals, credible policies, and importance to the domestic banking sector were clearly key. It is not even clear that these central banks consider such swap lines as an established part of their toolkit. Likewise, PBOC has on occasion shown willingness to turn its RMB swap lines into dollar loans, but again the conditions under which its vast pool of dollar liquidity might be made available to others are unclear. And would the ECB be willing to use its access to a Fed swap line to onlend dollars to EU counterparts in need to them, much like the Swedish Riksbank onlent euros obtained from the ECB to CEE central banks in the GFC?

It could be argued that this uncertainty about central bank swap line policies is a not a problem but a feature—to make sure financial supervisors and market participants in emerging markets do not take excessive FX risk. But this moral hazard argument is unconvincing. The insurance policy need not be unconditional: FX liquidity swap lines are only an appropriate remedy to deal with systemic or exogenous FX liquidity shortages, unrelated to a country’s policies or fundamentals. The EPG’s goal of securing the benefits of interconnected financial market for all would be closer at hand if central bank swap line policies were permanently on the books with clear activation criteria. This would provide positive incentives in normal times and prompt reassurance in crisis time, thereby containing systemic risk.