Brad Setser

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Where is my swap line? And will the diffusion of financial power Balkanize the global response to a broadening crisis?

by Brad Setser
October 18, 2008

Some emerging market central banks have noticed that they – unlike the Bank of Japan, Bank of England, Swiss National Bank and the European Central Bank – don’t have access to unlimited dollar credit through reciprocal swap lines with the Federal Reserve.

Peter Garnham of the FT, drawing on Derek Halpenny of Tokyo-Mitsubishi UFJ, observes:

Analysts say the unlimited dollar currency swaps set up between the Federal Reserve and central banks have helped bring stability to currencies through alleviating institutions desire to purchase dollars in the spot market to satisfy overnight funding requirements. “In contrast, the lack of currency swaps put into place between the Federal Reserve and emerging market central banks has likely helped to exacerbate the pick up in emerging market currency volatility” says Derek Halpenny, at the Bank of Tokyo Mitsubishi UFJ.

Think of Korea. There is “a shortage of dollars in the Korean banking system” – and Korean banks (and the Korean government) are scrambling to obtain them. That is likely adding to the pressure on the Won.

For all the talk about how the G-7 has lost relevance, in a lot of ways the recent crisis has reinforced the G-7’s importance. Banks in G-7 countries that borrowed in dollars have access to unlimited dollar financing from their central banks – dollar financing that comes from the fact that the main G-7 central banks have access to large swap lines with the Fed.

Banks in emerging market countries have no such luck.

Korea is a highly developed emerging economy. In a lot of ways it already has emerged. But it isn’t part of the G-7 (or G-10) and doesn’t have a swap line with the Fed that allows the Bank of Korea to borrow dollars from the Fed by posting won as collateral. That means that it has to rely on its foreign currency reserves – and its government’s capacity to borrow dollars in the market – to support its banks. Unless, of course, Korea could draw on a set of East Asian swap lines, and effectively borrow from Japan and China.

The old global architecture for responding to financial crises had, in my view, two essential components:

First, the major countries themselves were responsible for acting as the lender of last resort (and the bail-outer of last resort) to their own domestic financial system. Since the advanced economies banks’ had liabilities denominated in their own countries’ currency (US bank deposits are in dollars, British deposits are in pounds, and so on) this wasn’t hard.

And emerging economies had to turn to the IMF (sometimes reinforced with “second line” financing from the G-7) for dollar (or DM or pound or Euro) financing – whether to help meet their government’s own financing need, to help the emerging economies’ central bank provide a “hard currency” lender of last resort to its domestic financial system or to provide the emerging economy more foreign currency reserves to backstop its currency.

And since emerging market governments often borrowed in dollars or euros rather than their own currencies – and since many emerging market savers held dollar or euro denominated domestic deposits – emerging economies often had a need for significant financing.

This financing though was never unconditional – and was never unlimited. The $35b the IMF lent to Brazil in 2002 and the $20-25b the IMF lent to Turkey in 00-01 seemed big at the time, but it now seems small.

That architecture has been extended in one key way in the crisis:

European and Japanese banks facing difficulties refinancing their dollar liabilities now have (indirect) access to the Fed. The availability of $450b in credit from the Fed allowed European central banks to lend dollars to their banks without dipping into their (comparatively modest) reserves.

Emerging market central banks generally haven’t been as lucky. Their ability to lend dollars to their own banks is still limited by their own holdings of dollar reserves, their ability to borrow reserves from the IMF in exchange for IMF policy conditionality and their ability to borrow dollars from other emerging market economies with spare dollar reserves.

I am still trying to figure out how important a change this is – and to assess whether this new architecture makes sense for a global financial system that has changed fundamentally in some ways but not in others.

At one level, the stark divide between banks regulated by a the G-10 countries — which now have access to the Fed as a lender of last resort, albeit indirectly — and the banks regulated by the rest of the world seems a bit anachronistic. The center of the world economy won’t always be in the US and Europe.

On another level, a higher level of cooperation is possible among countries with broadly similar political systems than among more diverse group of countries with different political and economic systems. Similar forms of government, broadly similar (though changing) conceptions of the state’s role in the economy and a standing political alliance* facilitate the kind of cooperation among G-10 central banks that we have seen recently. Korea could presumably be drawn into the club without changing its basic character – Korea is a US ally and a democracy. Iceland could too, if it patches up its relationship with the UK – though the risk that Iceland’s government now has more debt than it can pay makes accepting Icelandic collateral in exchange for dollars a bit more of a problem.

Adding emerging economies with different economic and political systems from the G-7 countries into the “swap line” club might fundamentally change its character. Among other things, the US and Europe basically agree that their currencies should float against each other — and that they should regulate (or, until recently, not regulate) their financial systems in fairly similar ways.

There is another key difference between European banks’ need for dollars and many emerging markets’ need for dollars. European banks need dollars to finance their holdings of US mortgages and other US securities. If they didn’t have access to dollar financing, they would either have to borrow euros and buy dollars – pushing the dollar up (and hurting US exporters) or they would have to dump their US assets (hurting US banks holding similar assets). By lending to European central banks who then lent to their own banks, the US kept some European banks from being forced sellers of risky US assets – and in the process putting pressure on US banks. The US wasn’t acting entirely altruistically.

Emerging market banking systems by contrast often need dollar financing not to support their portfolios of US assets but to support their domestic dollar lending.

And it is now clear that a broad range of emerging economies do need access to the international banking system to continue the kind of breakneck growth that they have experienced recently — and have been caught up in the recent “deleveraging” of the global financial system. The FT’s Garnham again:

Analysts said emerging market currencies were being hit as foreign investors pulled money out of developing regions, driven by liquidity pressures from the credit crisis. “There seems little now that the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time,” said Derek Halpenny, at Bank of Tokyo-Mitsubishi.

Hungary is scrambling for euros.

Ukraine’s government is scrambling for dollars and euros – both to back its currency and to cover the maturing foreign currency borrowing of its banks.

Pakistan’s government needs dollars.

Korean banks are scrambling for dollars.

As are Russian banks. And Kazakh banks. And Emirati banks.

In many of the oil exporters, the government was building up foreign currency assets (reserves, sovereign wealth funds) while the private sector (including many firms with close ties to the government) were big borrowers from the international banking system. In the Emirates there is an added complication: Abu Dhabi was the emirate building up its external assets, while Dubai was the emirate doing the most borrowing.

But across the emerging world, external bank loans have dried up – creating a scramble for foreign currency liquidity.

And emerging markets (and Iceland) are looking for help from a range of sources. Their own central banks’ reserves (Korea, Russia, the Emirates) – or the foreign assets of their sovereign fund (Russia, China, Qatar, Kuwait, perhaps Abu Dhabi).*** The IMF, which is clearly back in business. European central banks (Hungary borrowed 5 billion euros from the ECB, the Nordics swap line with Iceland — which was recently tapped for euro 400 million). Russia (if it lends to Iceland).

Or China. Pakistan was certainly hoping that China would offer an alternative to the IMF; China though does not currently seem to be willing to hand Pakistan a sum that is equal to a couple of days of its reserve accumulation … .

This frantic activity suggests another potential change to the global architecture for responding to crises: the IMF no longer necessarily has a monopoly on hard currency crisis lending to the emerging world. It is now one player among many.

That is a fundamentally a reflection of the increased reserves of many large emerging economies.

China clearly has more dollars than in needs to maintain its own financial stability, which means that it is an alternative source of dollar financing. Russia may be too – though the large dollar and euro liabilities of Russian banks and firms implies that its own need for reserves could be quite large. It isn’t in as comfortable a position as China.

The diffusion of pools for dollar liquidity available to lend to troubled emerging economies seems at least to me to pose a fundamental issue for the G-7 countries that traditionally have been able to essentially decide on how the IMF’s funds are used among themselves: does the diffusion of financial power a major effort to bring the big emerging powers into the IMF’s fold – and thus to restore a de facto IMF monopoly on large-scale crisis lending? Or would the cost of any “deal” that would lead that countries like China and Russia and Saudi Arabia (which already has a large IMF quota) channel their lending through the IMF prohibitive?

The right answer isn’t clear to me. On one hand, granting the new players significantly more votes might make it next to impossible to build consensus in the IMF – and even a generous increase in the voting weights of key emerging economies might not be enough to convince them to channel their “crisis” lending through the IMF. China might not want to give up on bilateral lending in exchange for say 15% of the IMF’s voting shares. On the other hand, China hasn’t been keen to throw its reserves around over the past few weeks – preferring the safety of Treasuries to Agencies (or a dollar deposit in Pakistan’s central bank) – and might prefer conditional IMF lending to the risk of losing its funds …

For now it seems to me that the crisis likely has increased the gap between the G-7 (and G-10) countries and the rest of the world in a couple of key ways. Inside G-7 land, US banks could lend in euros (and European banks lend in dollars) secure that they had access to a lender of last resort – and the G-7 countries would still be in a position to offer hard currency loans to their “out-of-area” friends through the IMF. Outside G-7 land, countries would rely primarily on their own foreign currency reserves to cover the foreign currency liabilities of their banks – and potentially could use their own reserves to finance their crisis lending to other troubled countries.**

In some ways, that is a world where the gap between the G-7 countries and the rest would gets larger not smaller …

* Switzerland is an exception; it stands outside the “Western’ alliance but has access to the swap lines. But the Swiss have long been a big part of central bank cooperation – Basle and all.
** This leaves aside a key issue, namely the fact that countries outside the G-7 provide enormous quantities of unconditional dollar financing to the US through the buildup of their reserves. That reserve growth is partially a function of the need for countries outside the G-7 world of reciprocal swap lines to hold a lot more foreign currency – but it is also a function of these countries ongoing policy of pegging their currency to the dollar at an undervalued level. It also ignores the debate over whether sovereign funds investments in the US and European banks should be considered private investments for profit, or part of the global policy response to the crisis.
*** SWF Radar has been invaluable in tracking the use of sovereign funds to support domestic banking systems; many of my links are drawn from there.


  • Posted by a

    Twofish – Surely you realize that part of the GS operation manual is to have its former employees, now working in the Federal government, to give it any advantage possible. It is systematic, and it is looting. So I don’t find your view of GS (which seems to deny the looting) very coherent.

  • Posted by JKH


    “So the swaps might be NIIP neutral directionally, but increase future NIIP volatility, a very little bit.”

    This is true, probably.

    During the life of the swap, mark to market volatility would register directly as NIIP changes, provided that the relevant risk component (s) are captured as mark to market accounting in NIIP accounting. Not all market risk is marked to market in NIIP accounting. Some is marked; some remains at book. For example, Brad is the expert on this in the more significant and important areas of bonds and equities.

    More substantively, and regardless of the accounting treatment in NIIP or elsewhere, the cumulative effect of mark to market volatility on such a currency swap will be zero by the time the swap matures. Market value converges to book value at that point.

    NIIP is therefore cumulatively unchanged by the time the maturity or rollover date is reached.

    At that point, the historic volatilities observed are only an exercise in speculation on the opportunity cost of the original choice of market timing.

  • Posted by a

    Twofish : “Name four that are better.”

    Almost any hedge fund that’s still standing. In fifteen years GS almost went backrupt 3 times. Any hedge fund with that record would be bust now.

  • Posted by Pallj

    In the six years since the privatization of the main Icelandic banks, cheap credit is what allowed them to “blossom” and cheap credit also turned out to be their downfall.

    While they were state owned they were strictly regulated by the central bank. But since then their growth was exponential and no lender of last resort anywhere in sight. The central bank along with the rest of Iceland’s real economy are totally mismatched to their big behinds that urgently needed a chair for parking purposes, because the music had stopped. You can say this was simply bound to happen, because all good things come to an end at some point.
    There is no mystery to it. Big banks cannot be propped up by small economies.

    I am more confused about the American rescue packet, which in theory rescues the big European players as well. Intuitively I can’t figure out where the 700 billion actually come from? Under which mattress were they hidden? How come they hadn’t been spent on Iraq or something?

    I’m also confused about how the banks are going to start lending each other again. Supposing the 700b goes some way towards helping banks avoid defaulting en masse on their cheap credit loans, but is that enough to start the music playing again? Will these banks automatically start lending other banks money again, just because they have narrowly escaped ruin?

    It just seems like this crisis is not simply a crisis of confidence, but also a collapse of the illusion that there was tons of money in the system, when there wasn’t.

    Won’t it be inevitable that the big SWFs will have to become very involved in fueling the big engine. I just don’t see how the US can finance a full tank of gas without using the Xerox machine…

  • Posted by gillies

    “It just seems like this crisis is not simply a crisis of confidence, but also a collapse of the illusion that there was tons of money in the system, when there wasn’t.”

    yes, a collapse of the illusion that exponentially growing debt could be repackaged and classified as securities.

  • Posted by gillies

    fractional reserve debunking.

  • Posted by Twofish

    Cedric: I can’t help having this vision of low six figure income administrators at the Pentagon, CIA, FBI and NSA finally figuring out that this will all cost them budget money, loss of power, and handicap their ability to meet their public charters of national defense, intelligence, security and law enforcement.

    The nice thing about being in business and finance is that you can figure out ways of paying off the people that need to be paid off and taking a cut for yourself. You can do this if you generate wealth.

    There are three sources of power. Ideas, money, and guns. Ideas beat money. Money beats guns. The money lenders and businessman have often (and sometimes with good reason) been hated and resented, and there is this common fantasy if the utopia that would result if we just shoot the bankers. Sometimes, it has happened, but the results have never been utopian.

    Cedric: And there are rumblings worldwide that foreign powers are not really interested in participating in investment banking drama.

    No. Everyone is interesting in participated in the investment banking drama, they just want it on terms that they control. It’s pretty impossible to call yourself a world power without your own set of banks. Part of the military-economic complex.

    Cedric: I do believe there are more than 9 people in the world that are knowledgeable enough about the problem to regulate it from an international body that may be more buffered from political corruption.

    Anything that buffers an organization from political corruption also buffers it from political accountability. Some of the worst economic abuses in the recent times have been done by supposedly apolitical organizations like the IMF and the World Bank. The IMF and World Bank have traditionally leaned far, far too heavily toward international banks and far, far too heavily against third world farmers. It’s because there are too many bankers at IMF board meetings and not enough third world farmers.

    It’s not that bankers are evil, but if that power corrupts, and if you have a small inbred group of people in charge of something whether they are bankers, peasants, politicians, lamas, priests or taxicab drivers, you are going to have a mess because power corrupts everyone.

    Cedric: But in the meantime here’s a little PR piece indicating that $70B of the $700B bailout may already be slated for banking bonuses this year.

    A typical investment bank has about 10,000 to 20,000 employees, and the pay pattern is to have most of the pay in bonus, and they are going to be very lean this year.

  • Posted by Twofish

    Pallj: I am more confused about the American rescue packet, which in theory rescues the big European players as well. Intuitively I can’t figure out where the 700 billion actually come from?

    That depends on who gets elected.

    If Obama gets elected, then most of the bailout will be paid for by an increase in taxes on people making over $250,000/year, with stimulus packages given to people making less. Personally I think its a great idea since the rich have benefited disproportionately from the past few years of under-regulation, and so they should pay for it.

    If McCain gets elected, then he plans a tax cut and so obviously this bailout will be paid by the magic and wishful thinking money fairy that Republican presidents since Reagan have been invoking.

  • Posted by Scott

    It seems that it might be in the US’s interest not to support domestic dollar lending in the emerging markets, as the “breakneck” growth was driven by exports to the US and is not sustainable.

  • Posted by Pallj

    OK, so Obama suggests future taxes should do the trick, while McCain doesn’t think that sounds too good. But in the meantime it’s the tooth fairy that Obama wants to borrow the money from, and McCain wants to take it of, right?

  • Posted by Judy Yeo

    The situation has kinda calmed down after the Koreans rebooted their system over the weekend, the main issue with the tone fo your piece seems to be that alck of an overarching central “superman fgiure” means that all is close to descending into some form of anarchy? Is that only from the viewpoint of someone who has , for the longest time last century, been superman or the viewpoint of someone who’s in the “rest of the world” category that has been viewed as needing instruction, guidance and rescuing? Apologies if that was too sarky but sometimes the neo-imperialist tone is too much of a bait.

  • Posted by LB

    thanks for the douse of cold water at the end of the current proceedings.
    i personally found it quite refreshing.

  • Posted by moldbug


    In a nutshell, yes – MT risk is not amenable to modeling. You either do MT or you don’t. The goal of risk mitigation is to prevent an accident in which your bank alone blows up, not to guard against a systemic crisis requiring an LLR.

    “Giving up on banking” is a bit of an overstatement, perhaps. It is certainly possible to imagine banking in a zero-MT environment – structuring maturity-balanced assets and liabilitie. But, in a market which contains an LLR, zero-MT banking is not economically competitive. This is the usual vicious cycle of moral hazard. Moreover, the maturity mismatches on the collective balance sheet of the Western financial system are so gigantic that restructuring them as maturity-matched positions would demand an intervention of Napoleonic proportions.

    Keynes may have said it best with his “sound banker” quote. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he’s ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” “No one,” in this case, meaning the government. Moral hazard is endemic to the very nature of the Anglo-American banking system. It’s no surprise that the business cycle – a better name might be “banking cycle” – characteristic of this system has continued even into the 21st century.

  • Posted by a

    Cedric: But in the meantime here’s a little PR piece indicating that $70B of the $700B bailout may already be slated for banking bonuses this year.

    Twofish: A typical investment bank has about 10,000 to 20,000 employees, and the pay pattern is to have most of the pay in bonus, and they are going to be very lean this year.

    Salaries in banking are already high. “Very lean” is, I guess, a reflection of someone who works on Wall Street, who thinks getting 50% of last year’s record bonuses is equivalent to – like – poverty.

  • Posted by a

    I stand corrected. Bloomberg has an article out this morning that says that GS is planning to pay out *two thirds* of last year’s record bonuses. A lean year indeed.

  • Posted by JKH


    The “giving up on banking” notion related to the necessity of withdrawing from all risk taking (not just MT risk) in order to hedge black swan risk. I realize from your posts and comments that a zero-MT environment is quite conceivable, at least in theory, while still permitting other risk taking.

    The Keynes quote is excellent, as is normal with Keynes, although Chuck Prince continued to dance and didn’t exactly escape blame for being conventionally reckless.

    The other Keynes quote that captures perfectly the pandemic risk management disease goes something like:

    “Better to be approximately right than precisely wrong.”

  • Posted by Twofish

    GS is paying 2/3’s of last years bonuses. Lehman Europe is paying zero of last years bonuses.

    a: Salaries in banking are already high. “Very lean” is, I guess, a reflection of someone who works on Wall Street, who thinks getting 50% of last year’s record bonuses is equivalent to – like – poverty.

    Last year was not a record year. 2005/2006 were record years. Most people in a investment bank don’t make enough money to be affected by Obama’s tax increases. It’s not poverty, but the reality of the situation is that most people in an IB aren’t making the type of money that “Joe the Plumber” supposedly makes (but doesn’t). The salaries in an investment bank are *extremely* skewed, with a few people making huge amounts of money, and most people making not huge money, which is one reason that you have more sympathy for social redistributionist policies among people in Wall Street than you otherwise would expect.

    Investment bankers aren’t going to be facing poverty, but some of the people who depend on the 48% marginal tax rates that you see in New York City are going to get hit. For people working in IB’s, 48% of the bonus goes to public schools, parks, public transit, free clinics, social workers etc. etc. etc. so the people who do deal with poverty in NYC are quite worried since their funding is about to disappear. You go back to the 1970’s and look at the pictures of drug-infested, crime-infested, graffiti-filled slums. They don’t exist anymore. In NYC, trickle done does work because of the high tax rates.

    The real frightening thing is for someone with a physics or engineering Ph.D., banking the *ONLY* industry in the United States that can give you *ANY* hope of getting into the upper class. If you work in another other industry, you end up hitting the glass ceiling and you end up working for MBA’s and finance people that are generally clueless. You can start your own startup company in Silicon Valley, but most CEO’s in Silicon Valley end up working for the VC’s and bankers that run the company, who are sometimes clueless.

    That stinks, but that’s the way that it is. If you hate the system and it disgusts you, that’s great. I’m trying to give you the information you need to change it. Poverty doesn’t really bother me that much. I wouldn’t mind teaching community college for one fourth the salary that I’m making. However, what does make me angry is the lack of power. If you don’t have money, you don’t have power, and if you don’t have power, then other people are going to be making decisions about your life, and that is unacceptable to me.

    I’m not defending the system, I’m just describing it. However for a lot of scientists and engineers, Wall Street has given career options and opportunities that don’t exist anywhere else in the United States.

  • Posted by Twofish

    JKH: I realize from your posts and comments that a zero-MT environment is quite conceivable, at least in theory, while still permitting other risk taking.

    I don’t think that it is really. There are so many ways of doing maturity transformation that if banks don’t do it, someone else will.

  • Posted by RebelEconomist


    If MT is such a problem, then why don’t banks simply pass on the problem to their customers by saying to each “the bank reserves the right to limit withdrawals to x per day during times of excessive demand”? Assuming that MT has some efficiency advantages, it seems a shame to throw the whole thing out because of a risk that materialises once every few decades.

  • Posted by JKH


    I take your point. I suspect that in order for a zero-MT environment to be conceivable in theory, it would have to be prohibited by government in the defined local environment (e.g. all private financial institutions). Otherwise, MT is too natural a banking risk to be relinquished voluntarily by any normally dancing CEO.