Commentary on Political Economy

Tuesday, 4 August 2020

ALL HAIL THE MIGHTY US OF A!

Covid Supercharges Federal Reserve as Backup Lender to the World
www.wsj.com
The Fed has long resisted becoming the world’s backup lender. But it shed reservations after the pandemic went global. During two critical mid-March weeks, it bought a record $450 billion in Treasurys from investors desperate to raise dollars. By April, the Fed had lent another nearly half a trillion dollars to counterparts overseas, representing most of the emergency lending it had extended to fight the coronavirus at the time.
The massive commitment was among the Fed’s most significant—and least noticed—expansions of power yet. It eased a global dollar shortage, helped halt a deep market selloff and continues to support global markets today. It established the Fed as global guarantor of dollar funding, cementing the U.S. currency’s role as the global financial system’s underpinning.
Just as the Fed expanded its role in the U.S. economy to an unprecedented degree during the 2008 financial maelstrom, it has in the coronavirus crisis expanded its power and influence globally.
“The Fed has vigorously embraced its role as a global lender of last resort in this episode,” said Nathan Sheets, a former Fed economist who was the Treasury Department’s top international deputy from 2014 to 2017 and now is chief economist at investment-advisory firm PGIM Fixed Income. “When the chips were down, U.S. authorities acted.”
The value of the dollar has tumbled in recent weeks against other currencies as investors grow more troubled about the economic outlook and difficulty containing the coronavirus. Still, it is trading near levels recorded before the pandemic hit this year and above its long-term average on a trade-weighted basis, said Mark Sobel, a former U.S. Treasury Department official now at the Official Monetary and Financial Institutions Forum, a London-based think tank. Concerns that short-term declines in the dollar are an omen that its standing as the global reserve currency faces a threat are “vastly overdone,” he said.
The Fed supplied most of the money abroad via “U.S. dollar liquidity swap lines.” In essence, it lends dollars for fixed periods to foreign central banks and in return takes in their local currencies at market exchange rates. At the loans’ end, the Fed swaps back the currencies at the original exchange rate and collects interest.
By stabilizing foreign dollar markets, the Fed’s actions likely avoided even greater disruptions to foreign economies and to global markets. Those disruptions could spill back to the U.S. economy, pushing the value of the dollar higher against other currencies and damping U.S. exports—and the economy.
The risks to the Fed are minimal given that it is dealing with the most creditworthy nations and the most advanced central banks. But there are risks that investors come to expect a safety net for dollars that might lead to riskier borrowing during good times.
The Fed began deploying the swap facilities on March 15. By the end of March, it had expanded them to include 14 central banks while launching a separate program for those without swap lines to borrow dollars against their holdings of Treasurys. By May’s end, the total lent out under the programs peaked at $449 billion.
The Fed’s goal is to keep financial markets functioning, and the March events had the makings of a global panic with a resulting rush for cash. The aim was to prevent investors from dumping Treasurys and other dollar-denominated assets such as U.S. stocks and corporate securities to raise cash, which would have driven prices of those assets even lower.
‘Constructive effect’
Fed Chairman Jerome Powell in a May 13 webcast acknowledged the Fed’s global role more explicitly than his predecessors had during the last global financial crisis. The loans let foreign central banks supply dollars cheaply to their banking systems and stopped everyone in that chain from panic-selling assets like U.S. Treasurys to raise cash, he said: “It had a very constructive effect on calming down those markets and reducing the safety premium for owning U.S. dollars.”
Andrew Hauser, the Bank of England’s top markets official, in an early June speech said those swap lines “may be the most important part of the international financial stability safety net that few have ever heard of.”
On July 29, the Fed said it would extend the temporary programs, originally scheduled to end in September, through March 2021. “The crisis and the economic fallout from the pandemic are far from over,” Mr. Powell said, “and we’ll leave them in place until we’re confident that they’re no longer needed.”
The shift has brought little of the scrutiny the Fed saw during the 2008-2009 crisis. When Mr. Powell appeared before Congress for hearings in June, lawmakers didn’t ask a single question about the huge sums the central bank made available to borrowers abroad.
The Fed’s governing charter from Congress gives it the authority to operate the swap lines, which it has done in some form since 1962, when the Fed heavily debated whether it had the authority to conduct foreign-exchange operations. Congress could revoke these authorities if it didn’t approve of how the Fed was using them.

The Bank of England in April.

Photo: john sibley/Reuters
The swaps are structured so that the Fed’s foreign counterparts bear the risk of loans going bad or currency markets moving the wrong way. A large portion of the Fed’s overseas loans have recently been swapped back as markets around the world have recovered.
The Fed’s aggressive overseas lending has injected it into the world of foreign policy: Not every country gets equal access to the Fed’s dollars. Turkey, for example, has appealed unsuccessfully for dollar loans from the Fed to support its sinking currency, according to public comments made in April by the U.S. ambassador to Turkey, David Satterfield. A representative for the Turkish central bank didn’t respond to a request for comment.
Those decisions are based on creditworthiness, but political considerations could pose a threat to the Fed’s independence, said Mr. Sheets, the former Fed economist. When the Fed rolled out the lending program during the 2008 financial crisis, central-bank officials consulted with the leadership of the Treasury and State Department to make sure any operations were consistent with broader U.S. objectives, he said.
“The Fed was keenly aware of this tension that, yes, this was monetary policy, but it was abutting some broader issues that were not typically the Fed’s area,” said Mr. Sheets. Concerns that such lending programs could suck the Fed into broader foreign policy entanglements were a “meaningful constraint” on the expansion of the swap lines, he said.
The moves have also left the world ever more tied to a single country’s economic management and central bank. Efforts have persisted for years to dilute the dollar’s central role, via the euro, then the Chinese yuan. But knowing the Fed is willing to step in has led banks, businesses and investors to flock to the U.S. currency.
This gives the U.S. enormous power—to punish foreign banks for violations of U.S. sanctions, for instance, or to consider options like breaking the Hong Kong dollar’s peg to the dollar, something U.S. officials considered earlier in July, The Wall Street Journal reported, to punish China for its treatment of the city, before shelving the idea.
It also has produced a familiar cycle, said Stephen Jen, chief executive of Eurizon SLJ Capital Ltd. in London and a longtime currency analyst and money manager. Investors value the dollar for its safety. But every time there is a major market stress there is a run to the currency, leading to breakdowns in the market, which forces the Fed to step in, which reinforces investors’ faith in the dollar, he said. “People have become more dependent on the dollar than any other currency,” he added.
The Fed pioneered the current version of central-bank swap lines in 2007, when rising U.S. subprime-mortgage delinquencies jolted short-term debt markets and made it hard for big European banks to borrow dollars. Initially, the Fed lent to some European banks’ U.S. subsidiaries. It later rolled out swap lines to two foreign central banks, allowing the Fed to lend dollars with less risk, and expanded them to a dozen others over 2008 and 2009.

The Fed’s swap lines ‘may be the most important part of the international financial stability safety net that few have ever heard of,’ says Andrew Hauser, the Bank of England’s top markets official.

Photo: Simon Dawson/Bloomberg News
The Fed activated some of the swaps again in 2010 and 2011, as Eurozone debt problems mounted, and set up standing facilities with five major central banks in 2013. One Fed bank president formally objected, saying that the swaps effectively let European banks borrow at lower rates than U.S. banks and that they were an inappropriate incursion into fiscal policy.
When coronavirus shutdowns hit the U.S. and Europe in March, oil prices plunged and stocks plummeted. Companies drew down bank credit lines, socking away dollars to pay workers and bills as revenue vanished. Financial markets showed alarming signs of dollar demand.

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