Today we are delighted to present a guest contribution for you go through Joshua Eisenman (University of Southern California).
At the Reykjavik Roundtable on Global Economic Challenges, organized by Robert McCauley, Robert Aliber, Gylfi Zoega and Mar Gudmundsson on 1-2 September 2022, I outlined my This is Hero and Gurnam Pasirica exist Background to past and future challenges.
The Covid-19 crisis is yet another test of the robustness of the dollar’s dominance as the US, EU and China’s share of global GDP approaches around 20% when adjusted for purchasing power parity. During the COVID-19 crisis, in the face of severe stress in the offshore U.S. dollar funding market, the Federal Reserve provided U.S. dollar liquidity to the global economy by reactivating or strengthening swap arrangements with other central banks; and establishing a new The repo tool for FIMA. The FIMA Repo Facility allows the FIMA Central Bank and other international monetary authorities with accounts at the New York Fed to enter into repurchase agreements with the Fed. Approved FIMA account holders can temporarily exchange their U.S. Treasury holdings at the Federal Reserve for U.S. dollars, which can then be made available to institutions within their jurisdiction. In addition to selling securities on the open market, the facility provides holders of foreign official Treasuries with an alternative temporary source of U.S. dollars at a supporting interest rate.
Studying the impact of these facilities shows that access to Fed liquidity is driven by close financial and trade ties with the United States. An economy’s share of U.S. trade and military alliances with the U.S. are positive factors associated with securing a Fed swap deal. An economy with higher exposure to U.S. banking and financial risks and closer trade ties with the U.S. tends to have easier access to Fed liquidity through swap lines or FIMAs. Economies with a large share of global trade, whether or not they are major U.S. trading partners, have access to more dollar liquidity through the Fed. Economies that are under pressure to appreciate the dollar and have more volatile local currencies are more likely to auction more dollars in domestic markets. Swap-related announcements caused currencies to appreciate against the U.S. dollar and reduced those currencies’ deviations from the CIP.
Auctions by the big four central banks – the European Central Bank, the Bank of Japan, the Swiss National Bank and the Bank of England – peaked at around $112 billion per day in mid-March, orders of magnitude larger than auctions at all other central banks (Figure 1). Dollar auctions by these major central banks have spillover effects: they cause other currencies to appreciate temporarily against the dollar, reduce CIP bias, and consistently lower sovereign bond yields in other economies. However, dollar auctions by non-major central banks that have access to Fed tools have not had a meaningful impact on key domestic financial variables. The effects of major central bank auctions are similar for economies with different financial and trade ties to the United States, as well as for economies with different balance sheet currency and foreign debt exposures. As a result, major central bank auctions benefit even more vulnerable economies.
figure 1: Many advanced and emerging market central banks auctioned dollars during the COVID-19 crisis. Source: Aizenman, J., Ito, H. and Pasricha, GK (2022). Central bank swap arrangements in the midst of the covid-19 crisis. International Monetary and Finance Journal.
Notably, under the FIMA repo facility, the Fed provides overnight dollar liquidity in exchange for existing U.S. Treasury bonds held by these institutions, which can be rolled over. The FIMA facility is expected to reduce the need to sell US Treasuries and ease pressure on the market. As an instrument backed by U.S. treasures (rather than foreign currency in swap lines), FIMA does not expose the Fed to credit risk from foreign central banks. The Fed’s facility appears to have succeeded in limiting the sale of U.S. Treasuries—economies able to use the Fed’s facility saw a smaller decline in the average percentage of U.S. Treasury holdings between February 2020 and April 2020 (Figure 2). This graph plots the percentage change in U.S. Treasuries holdings between the end of February and the end of April 2020 for economies with or without access to Fed loans, as of the end of February to the end of April 2020. Economies with Fed loans include the Fed swap line as well as Hong Kong (China), Indonesia, Chile and Colombia. Economies without Fed facilities are among the other 84 for which data is available.
figure 2. Economies receiving Fed liquidity lines saw smaller declines in U.S. Treasury holdings between February 2020 and April 2020
The above results confirm the “narrow, broad effect” of the US Federal Reserve’s swap lines during the GFC and the Covid-19 crisis. A positive interpretation of the Fed’s experience with bilateral swap lines and FIMAs is that “mission accomplished” – the Fed has successfully stabilized the global financial systems, encouraging them to provide dollar liquidity to systemic institutions. The timing and magnitude of these innervations are ample, triggered by heightened global instability and a “flight to the safety of the dollar.”These steps reinforce the notion that the Fed is committed to defending the global stability of the U.S. dollar network, consistent with Gurinchas and Rey (2007). The delineation of support services reflects a balancing act: the Federal Reserve’s emergency credit lines to foreign central banks provide global support, preventing panic balancing from attempts to liquidate dollar exposures amid a sell-off, in this case, ” “Safe haven” ended in self-fulfilling financial crisis in lender of last resort (Diamond and Davig (1983)). Foreign central banks act as lenders of last resort within their jurisdictions.
One might hope that the Fed has established the credibility of its policy so far and will develop a blueprint for an emergency BSL at a time when future high volatility triggers global risk aversion and a shift to quality. However, there is no reason to assume that the future will be like the past. Future challenges to the dollar’s standards could undermine the Fed’s effectiveness or willingness to provide global support services. We end with open-ended questions about future developments, the answers of which will determine the robustness of the dollar’s dominance and the functioning of the global financial system in perilous times:
- Will the closer alliance between the US and EU survive after a Biden administration? During the global financial crisis and the Covid-19 crisis, the Federal Reserve and the European Central Bank cooperated by invoking similar policy stances, providing positive spillover effects. In the future, the US government may return to implement an “America First” isolationist policy, which may raise questions about the credibility and depth of the Fed’s policy of supporting the US dollar.
- Will the deepening of euro sovereign bonds and a greater commitment from the ECB and the EU to back these bonds undermine the dollar’s dominance? These trends are likely to strengthen the euro’s global position by increasing the size, liquidity and safe-haven status of euro sovereign bonds issued by euro area countries.
- The weaponization of dollar dominance and greater geopolitical tensions between the West (OECD countries) and the East (China, Russia and their allies) would lead to increasingly fragmented trade and local barter and credit arrangements, thereby weakening Dollar dominance?
- Will QE exits and low interest rate policies triggered by adverse stagflation shocks limit the future application of BSL and shake USD dominance?
- Are we moving from the illusory era of stable “irreversible globalization” into a period of fragmentation that rhymes with the first half of the 20th century?thcentury, this time with the destructive power of modern technology, modern global warming and climate volatility, and the global population more than doubling?
Therefore, there is a good chance that the dollar standard will be tested again in a more challenging environment, and the Fed’s policies may be less successful.
Optional reference:
Aizenman, J. (2022). The Fed’s Swap Lines: Narrow Circles, Broad Implications?.
Aizenman, J., Ito, H. and Pasricha, GK (2022). Central bank swap arrangements in the midst of the covid-19 crisis international journal of money and finance.
Board, MD, O/F. Humpage and J. Schwartz. “The evolution of Fed swap lines since 1962.” IMF Economic Review 63.2 (2015): 353-372.
Diamond, Douglas W. and Philip H. Dybvig. “Bank runs, deposit insurance and liquidity.” Journal of Political Economy 91.3 (1983): 401-419.
Goldberg, LS, Lerman, R. and Reichgott, D. (2022). The Global Role of the U.S. Dollar: Revisiting the Status Quo (No. 20220705a). Federal Reserve Bank of New York.
Gourinchas, PO and H. Rey (2007) ‘From World Banker to World Venture Capitalist: American External Adjustment and Excessive Privilege‘, in RH Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment, Chicago: University of Chicago Press.
Liao, G. and Zhang, T. 2020. Hedging Channels for Exchange Rate Determination. FRB International Finance Discussion Paper (1283).
McCauley, RN and Schenk, CR (2020). Central bank swaps then and now: Swaps and dollar liquidity in the 1960s.
Obstfeld, M., Shambaugh, JC, and Taylor, AM (2009). Financial instability, reserves and central bank swap lines in the 2008 panic. American Economic Review, 99(2), 480-86.
This article is by Joshua Eisenman.
