Don't Freeze Out Emerging Markets From Currency Swaps

Brett House and Kevin English on why central bank swaps should be channeled through the IMF.
By: /
July 2, 2014

On the 70th anniversary of the July 1, 1944 Bretton Woods conference – the landmark gathering that created the International Monetary Fund (IMF), the World Bank and later the World Trade Organization (WTO) – it’s hard to know whether it’s the best or worst of times for multilateralism.

On one hand, as American political scientist Daniel Drezner details in his recent book, The System Worked, international co-operation trumped fear, nationalism and protectionism in response to the 2008 financial crisis and rescued the world from a 1930s-style economic death spiral.

On the other hand, more recent events belie any notion of a golden age of internationalism. The WTO is being undermined by mega-regional trade deals and protectionism is on the rise. Emerging markets are getting side-swiped by the end of quantitative easing. Europe remains consumed with its own existential problems, while Southeast Asia, the BRICS and Latin America consider regional alternatives to the IMF.

No wonder U.S. president Truman once quipped that he was fed up with two-handed economists.

Yet, one of the biggest complications for Bretton-Woods multilateralism goes largely unnoticed: a new web of currency-swap lines between the world’s major central banks.

A swap between central banks allows them to exchange their currencies at prevailing exchange rates with an understanding that they’ll reverse the swap at a predetermined rate at a fixed future date. A country in distress can fire up its printing press, mint some of its own money, swap it for a stronger currency, and use these dollars, euros or pounds to service its debt or pay for imports.

During the 2008 crisis, the so-called C6 – the U.S. Federal Reserve, the Bank of England, the ECB, the Bank of Japan, the Swiss National Bank, and the Bank of Canada – created a network of bilateral swap agreements to ensure they would be able to draw on each others’ funds in the advent of a liquidity crisis. In 2013, the C6 moved to make these arrangements permanent.

That’s great for them, but it’s as if the cool, rich kids are freezing out the nouveau riche strivers, the smaller nerds and the classmates from the wrong side of the tracks.

Left to its own devices, the rest of the world has to self-insure against sudden droughts of liquidity by accumulating vast foreign exchange reserves and building competing regional arrangements.

Between 1996 and 2013, emerging market reserves soared from 9 to 27 per cent of their collective GDP. China’s hoard is a whopping $3.8-trillion (U.S.): 41 per cent of its GDP and twice the size of Canada’s economy.

Every excess dollar held in reserves is a dollar that could have been used to pay down debt or drive investment. IMF staff estimate that excess reserves cost emerging markets around 0.5 percentage points of growth each year during the first decade of the 2000s.

The cheaper option – exploiting economies of scale by pooling reserves amongst the IMF’s 188 members – also gets undermined and, along with it, the IMF’s efforts to anticipate and prevent future crises.

Furthermore, when large economies intervene in currency markets to acquire rainy-day funds, it’s nearly impossible to distinguish between countries accumulating reserves for self-insurance and others acting to depress the value of their currencies and make their exports cheaper. Either way, other small, open economies with flexible exchange rates, such as Canada, get hurt.

Left out of the C6 and rocked by the “taper tantrum” as the U.S. Fed slows its asset purchases, some emerging markets want to channel central bank swaps through the IMF. Canada should join them.

During the IMF-World Bank’s spring meetings in April, Singapore’s Tharman Shanmugaratnam, chairman of the IMF’s highest governing committee, called for “quick assistance, quick liquidity at times of crises to well-managed countries without conditionality.” Implicitly, it was a call for a very short-term IMF lending window to cover three to six month liquidity needs: in short, a swap.

India Reserve Bank Governor Raghuram Rajan more explicitly noted that existing swaps could be moved into the IMF, thereby spreading associated credit risks more widely and dampening the political pressures that weigh on bilateral and regional arrangements.

The prospect of new IMF financing raises fears that incentives for countries to implement good policies could be weakened. Indeed, the money would have to be of sufficient size and with few strings attached: the limits on past IMF swap-like facilities, such as the Short-Term Liquidity Facility, were too tight and they were eliminated for lack of use.

But any new IMF lending facility would be available only to countries with decent track records and it would provide financing for no more than six months. That’s enough time for markets and the IMF to assess whether a country faces a liquidity hiccup or more profound problems that require a traditional IMF program and debt restructuring.

Instead of the IMF committing upfront to huge, balance-sheet busting lending programs that pay off private creditors and saddle crisis-riddled countries with even more inflexible official debt, as happened in Greece, a “wait and see” approach with a short-term IMF swap would allow the costs of fighting a crisis to be shared more equitably between private and public creditors.

That’s a win on three fronts: the international system gets stronger; the costs to the IMF (and Canada) of fighting future crises get reduced; and private lenders get an incentive to stop overlending to marginal countries.

The power of C188 trumps the exclusivity of the C6.