Dollar Swap Lines: Welcome Support but Only Part of the Solution

March 19, 2020

Early on March 19, the Federal Reserve announced the establishment of temporary U.S. dollar swap lines with an expanded list of central banks, including a handful of emerging market economies. The move comes just days after the Fed lowered the cost and extended the maturity of standing U.S. dollar swap lines with the European Central Bank (ECB), Bank of Japan, and Bank of England, among other advanced economy central banks. Consistent with other Fed actions this week intended to address the financial fallout from the COVID-19 pandemic, the reintroduction of dollar swaps resurrects an emergency facility created during the global financial crisis (GFC) to ensure that demand for U.S. dollars—the currency at the center of the international financial system—can be met. While critical to stabilizing financial markets, dollar swap arrangements alone cannot meet global funding needs, which require additional resources be brought to the table.

Q1: What are central bank swaps?

A1: The Fed’s dollar swap lines are “designed to improve liquidity conditions in dollar funding markets in the United States and abroad by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress.” Effectively, the swaps provide participating central banks with dollars in exchange for their local currency (e.g., the Fed provides U.S. dollars to the Bank of Japan in exchange for an equal value of Japanese yen at the market exchange rate). The Bank of Japan then provides dollars to institutions in its jurisdiction—namely, Japanese banks—who in turn channel funding to their clients.

The swap “unwinds” at the end of the maturity period and can be extended or “rolled over” as long as the facility remains open—in the case of central banks covered under today’s announcement, at least six months. At the end of the period, ideally when market conditions have normalized, the central banks “unwind” the swap: the Fed gets back its dollars, the Bank of Japan gets back its yen, using the same exchange rate used in the initial draw. Importantly, and as noted in the Fed’s own description of central bank liquidity swaps, the Federal Reserve is not a counterparty to any loans extended by the foreign central bank—meaning the foreign central bank and not the Fed bears the credit risk associated with the loans it makes to institutions in its jurisdiction.

Q2: What countries have access to the Fed’s dollar swap lines?

A2: The Federal Reserve has standing U.S. dollar liquidity swap lines with the Bank of Canada, Bank of England, Bank of Japan, ECB (the central bank for Euro area countries), and Swiss National Bank. These lines were first created during the GFC in December 2007, reauthorized in May 2010 during the Euro area debt crisis, and converted to standing arrangements in October 2013. Sunday’s announcement by the Fed lowered the cost of using these standing swap lines and extended the available maturity from one week to 84 days.

Today’s announcement reestablishes dollar swap lines with the Reserve Bank of Australia, Banco Central do Brasil, Danmarks Nationalbank (Denmark), Bank of Korea, Banco de México, Norges Bank (Norway), Reserve Bank of New Zealand, Monetary Authority of Singapore, and Sveriges Riksbank (Sweden). With the swap lines announced today, plus the standing swap lines, the coverage of Fed dollar swaps is identical to December 2007. At the same time, some of the world’s largest economies are not covered by these arrangements, among them Argentina, China, India, Indonesia, Russia, Saudi Arabia, South Africa, and Turkey—all members of the Group of 20 (G20), which represents the world’s largest economies. In some cases, these countries have large dollar reserves they can access to help meet dollar demand. Others have capital controls that can limit outflows and lessen the need for dollars. However, many emerging market and low-income countries will need to seek other sources of funding or face shortfalls that could paralyze their economies.

Q3: Why did the Fed reintroduce these swaps?

A3: While much of the focus has been on price movements in equity markets in the United States and around the world, financial markets globally and across all asset classes have been impacted by what one analyst rightly refers to as “interlocking public health, economic, and financial crises brought on by the pandemic.” Unprecedented uncertainty has led to a spike in dollar demand globally, as investors seek the relative liquidity and safety of dollar-denominated assets and short-duration, government-guaranteed assets in particular. However, that demand presents a problem for many countries who have dollar obligations but no way to access dollars under current market conditions. Enter dollar swap lines, which as described above, provide dollars to central banks who can then on-lend to banks and their clients.

Q4: Will the swaps be sufficient to meet funding needs?

A4: The Fed and other global central banks deserve a lot of credit for moving quickly in an attempt to restore the smooth functioning of financial markets. The Fed’s dollar swap lines are an important part of that effort, but they alone will not be enough. The Institute of International Finance has warned of the “terrifying” sudden stop in capital flows across emerging markets. While Fed actions this week are essential, they are far from sufficient. First, many of the hardest hit economies are not eligible for swaps; second, swaps are intended to address short-term market distortions, not fundamental re-evaluations or economic hits of the magnitude forecast.

International financial institutions—the International Monetary Fund (IMF), World Bank, regional development banks, and regional financing mechanisms such as the European Stability Mechanism and Chang Mai Multilateralization Mechanism—will have to be mobilized to provide the financing needed to respond to what is an unprecedented global shock. On Monday, the IMF’s managing director announced that some 20 countries had already expressed interest in crisis financing, a number that will no doubt rise. The IMF also indicated that it has $1 trillion in lending capacity to meet financing needs; at a time when individual country responses are measured in the hundreds of billions of dollars, more firepower may well be needed. Of course, unlocking that firepower will depend on unprecedented global cooperation, something that to-date has been sorely lacking.

Stephanie Segal is a senior fellow with the Simon Chair in Political Economy at the Center for Strategic and International Studies in Washington, D.C.

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