United States Trade-Weighted Dollar IndexIndex (Jan 2006 = 100)
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.
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.
Swap Line Usage by Foreign Central BanksReported by the Federal Reserve
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.
Swap Line Usage by Foreign Central BanksReported by Foreign Central Banks
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.
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.