What Market is Under Stress

The United States dollar (USD) plays an outsized role in international finance. All around the world, firms and banks write financial contracts denominated in the USD even when no American business is part of the transaction. When the dollar rises in value relative to other currencies (appreciates), it can be harmful to dollar borrowers in foreign countries. For example, consider a barbershop in Mexico that borrows startup capital in USD, and so must pay interest in USD. Presumably, all of its revenues are in Mexican pesos. If the dollar appreciates, then the peso-denominated revenue needed to meet interest payments is now larger.

In times of global economic uncertainty, the USD appreciates. High demand for safe assets, which are typically dollar denominated debt issued by the United States Government, drives up the value of the dollar. Financial and corporate borrowers, who are seen to be more risky than governments, also face tighter credit and higher borrowing costs as lenders contract dollar credit to these entities.

What is the Policy Response to the Coronavirus Crisis

Demand for dollars by the private sector in times of crises cannot be directly fulfilled by foreign central banks who lack the ability to create dollar liquidity. While USD reserves at central banks are useful, they can be insufficient. Swap lines between the Federal Reserve and foreign central banks can allow foreign central banks to expand the supply of USD credit to borrowing institutions.

Swap lines work by having central banks exchange currency (typically at the prevailing spot exchange rate) while simultaneously entering into a forward agreement to exchange back the currency on some pre-specified date in the future, plus interest. For example, the Federal Reserve may sell $100 to the ECB in exchange for €100 (implying the spot exchange rate is 1$ = 1€). At the same time, they enter into an agreement to buy back $100 in one week in exchange for €99 (implying the expected spot exchange rate in one week is 1$ = .99€, plus interest). Interest is set as the overnight index swap (OIS) rate, plus some margin. The foreign central banks then agree to lend such funds at this interest rate to local borrowers.

The key advantage to using swap lines for the Federal Reserve is that they are not a counterparty to the borrowing firm in the foreign country. Instead, they are only exposed to risk through the swap with the foreign central bank, who is unlikely to default. Instead, the foreign central bank takes on risk by lending dollars to local institutions. One may wonder what the Federal Reserve does get out of this arrangement. During the crisis, probably not much. However, in normal times the international role of the dollar allows US entities, such as governments and firms, to borrow at lower interest rates than they otherwise would, due to demand for dollar assets.

Prior to the coronavirus crisis, Canada, England, Japan, the euro area, and Switzerland all had swap lines to access dollar liquidity since. On March 15, 2020, the margin on dollar borrowing was lowered by 25 basis points. The new rates will be the U.S. dollar OIS rate plus 25 basis points. The maturity of the swap arrangements was increased to allow for three month contracts, as well. On March 19, the Federal Reserve opened additional six-month swap lines with Singapore, South Korea, Brazil, Sweden, Australia, New Zealand, Mexico, Norway and Denmark. These countries also briefly had access to swap lines during the Great Recession. On March 20, 2020, the auctions on the standing facilities were changed from weekly operations to daily operations.

As of the week ending March 18, 2020, the Federal Reserve had reported only $45 million outstanding worth of central bank swaps. The following week saw swap line usage rise to almost $200 billion outstanding, driven mainly by the ECB and the BoJ.

What is the Historical Precedent

Swap lines were used as far back as the 1960s during the Bretton Woods era. Throughout the 1960s and 1970s, the Fed used swap lines to prevent gold outflows. With the notable exception of Mexico during the 1970s and briefly following the September 11, 2011 attacks, swap lines were not extensively used for a few decades following.

In December 2007 and throughout the financial crises, these swap lines were reopened. They were set up on a temporary basis at this time, until May 2010 when they were formally introduced as permanent standing arrangements. Today, there exist approximately 160 bilateral swap lines worldwide.

What have been the results?

Other central banks publish swap operations on a more frequent basis. At the Bank of England, the week beginning March 18th saw approximately $15 billion dollars worth of operations, divided roughly evenly between one-week and three-month operations. The following week beginning March 23rd has seen only $5 million thus far.

At the Bank of Japan, which publishes daily operations, the week beginning March 23rd has seen approximately $35 billion dollars worth of operations. The Swiss National Bank, which also publish daily operations, have had roughly $711 million dollars the week beginning March 23rd.

These measures are larger than the swap line usage during the European debt crisis in 2011. However, they are still smaller than what was seen during the Great Recession.

What Is the Academic Evidence

Bahaj and Reis (2019) study the swap lines created during the Great Recession. They find that the swap lines lowered the average size of the CIP deviation. These changes have effects on financial variables, in particular flows into dollar assets and lower bank funding costs.

di Mauro and Zettlemeyer (2017) discuss how international swap lines fit into the international financial system. While organizations such as the International Monetary Fund (IMF) can offer fiscal support to countries, only specific central banks have the ability to offer unlimited liquidity in reserve currencies. Swap lines can work to backstop the entire financial system, especially as it has become increasingly interconnected over the years.

What Market is Under Distress?

The United States treasury market is one of the largest global security markets. As a large country with a stable political situation, an independent central bank, a large tax base, and a dynamic economy, lending to the United States Government is viewed as the most risk-free investment opportunities. Accordingly, movements in the borrowing rate for the United States Treasuries can be viewed as a measure of risk. This is especially so when borrowing rates move without any action on the part of policymakers to increase or reduce the national debt. (Krishanmurthy and Vissing-Jorgensen 2012).

In uncertain times, demand for safety drives investors to buy US treasury securities. This typically reduces the yield for such securities. Hence, in times of global distress (such as the coronavirus pandemic), one should expect to see declining US treasury yields.

Such a decline is exactly what happened, at least initially. 10-Year constant maturity yields, published daily by the US Treasury, began falling in late February from around 1.2% to around 0.5% on March 9th. However, between March 9th and March 18th, yields began to rose, which is puzzling given the logic outlined above. Because risky securities, such as stock markets, were in free-fall at the same time, one may wonder what kinds of assets investors, including foreign governments, were purchasing if not securities.

One speculation for why yields were increasing is that foreign governments were converting treasuries into even more liquid dollars, putting pressure on treasury markets. Unfortunately, most central banks around the world only report weekly data on the total amount of reserves combining US treasury securities with currency holdings. Unfortunately, until the IMF releases their updated reserve reports in a couple of months, this is still speculative.

What Is the Policy?

On March 31, 2020 the Federal Reserve announced the establishment of a temporary repurchase agreement facility for foreign and international monetary authorities, known as the FIMA Repo Facility. The FIMA Repo Facility allows foreign central banks to borrow money via repurchase operations with the Federal Reserve Bank of New York. The FIMA Repo Facility will begin operations on April 6th, and continue for at least six months. The FIMA Repo Facility works by entering into a repo operation with a foreign counterpart. Specially, using only US treasury securities as collateral, the New York Fed will lend dollars on an overnight basis, with interest equal to a 25bp margin over the interest on excess reserves.

What Have Been the Results?

Until data becomes publicy available, it is impossible to determine how much use there is among foreign central banks and international monetary authorities of this new repo facility. However, it is possible to make an educated guess as to which countries might benefit from the opening of the FIMA facility. To do this, we can calculate how many treasuries a country holds relative to the size of its financial sector. Countries with large holdings of treasuries will have relatively greater access to credit through FIMA, all else equal.

While in theory this ratio should be easily calculated, in practice it is not due to data limitations. The United States only reports foreign holdings by country of residence without breaking down between private and official; however, the US does report aggregate foreign official holdings of long-term treasuries, the dominant type of official holding. Relative to total foreign holdings of long-term treasury securities, total official holdings (aggregated across all countries) is roughly two thirds. We can use this number to estimate the ratio of long-term securities relative to the financial sector among reported countries.

In the figure below, we plot by country the ratio of total long-term treasuries (multiplied by two-thirds) relative to non-financial sector loans (the latter available from the Bank for International Settlements). Most countries have just under 10% of non-financial credit available as US treasury securities. However, there is wide variation across countries. Some emerging markets , such as Brazil, have a ratio four times as high as other emerging markets, such as Turkey. Countries with very low ratios, such as many Eurozone countries, likely hold more reserves in euros rather than dollars.

Is Europe doing Quantitative Easing?

Much like the United States, the euro area also has experience with quantitative easing (QE) type programs. Starting in October 2014, the European Central Bank (ECB) began purchasing marketable securities, such as government, corporate, or asset-backed securities, via the Asset Purchases Programme (APP). These purchases continued until December 2018, when the ECB stopped purchasing new securities and only reinvested the principal repayments from maturating securities.

The APP was restarted beginning November 1, 2019 with net purchases totaling around €20 billion per month. In his press conference, then-ECB President Mario Draghi outlined three reasons for restarting this program. First, the slowdown in the euro area was larger than expected. Second, ongoing trade wars and Brexit negotiations increased the risks of further declines in output. Third, inflation expectations were extremely low.

QE was enlarged during the beginning of the Coronavirus crisis. In addition to the €20 billion per month, on March 12, 2020 the ECB announced an additional €120 billion per month of net asset purchases until the end of 2020. The APP is not the only QE-type program in use in the euro area. On March 18, 2020, the ECB announced the Pandemic Emergency Purchase Programme (PEPP). This program would have the authority to purchase all eligible securities under the APP. Additionally, the program could purchase some securities not eligible for the APP, in particular Greek government debt. The program has an overall size of €750 billion, and would last at least until the end of 2020.

The results of the QE type programs can be readily seen in euro area yields relative to Germany. Beginning at the end of February 2020, spreads began to rise, reflecting uncertainty and the expectation that European governments may have to resort to fiscal stimulus in order to boost their domestic economies. Even after the QE announcement on March 12, 2020, markets were still sufficiently worried about European governments that spreads continued to rise. Only after the introduction of the PEPP did yields begin to fall.

Much of the academic literature on QE applies to the APP and PEPP. Studies of the APP, such as Andrade, Breckenfelder, De Fiore, Karadi, and Tristani (2016) or Eser, Lemke, Nyholm, Radde, and Vladu (2019), find similar results in that yields on government bonds declined following the imposition of the program.

There are at least two important differences with implementation of QE by the ECB compared with QE by the Federal Reserve. First, individual governments within the euro area may encounter fiscal issues, such as default, which can lead to debt restructuring. Such debt restructuring could impair the ECB’s balance sheet, affecting the transmission of monetary policy. Along the same lines, by lending to specific governments or by reducing yields in secondary markets, the ECB may inadvertently create a moral hazard problem that may make future crises more difficult to stabilize. For example, governments may internalize the fact that the ECB will provide assistance in future crises, and so run larger budget deficits than they may have otherwise (see, for example, De Grauwe (2012)).