This is a more technical post.
When financial panic spread even to sound emerging economies after Lehman collapsed in September 2008, the Fed responded by extending swap lines to central banks in Brazil, Korea, Mexico and Singapore, while the ECB provided them to Hungary and Poland. These unprecedented moves played a key role in quelling the panic.
The four emerging economies that the Fed helped were all well-run, but a new paper suggests that “the exposure of US banks was the single most important explanation for why the US selected to swap deals with the ‘chosen four’, as a summary on Vox explains.
Might such swap lines substitute for the vast foreign-exchange reserves that many emerging economies have felt compelled to accumulate?
Only to a limited extent, the paper concludes:
there are clear limits to substitutability between swaps and reserves. By and large swap lines are extended only to fundamentally sound and well-managed emerging markets, and to important trade partners. Crucially, sound fundamentals include healthy levels of foreign-exchange reserves. The highly selective nature of swap recipients means that a majority of developing countries will not have access to swap facilities. While swaps can contribute to the global public good of global financial stability, in fact large central banks provide liquidity support only when it is in the self-interest of their respective countries to do so. The inclusion of countries such as Argentina and Belarus – not known for strong fundamentals or sound management – among the Bank of China’s swap recipient countries points to the overarching dominance of export markets as the key criterion. Following from this, the growth of yuan-dominated swap lines may be a precursor to the eventual emergence of the yuan as a new reserve currency.
When market confidence is shattered, foreign-exchange market intervention to stabilise exchange rate becomes ineffective, even if the economy has sound fundamentals. That is, reserves fail to perform their precautionary or self-insurance function when the unlikely becomes the reality. In fact, in the case of Korea, declining reserves themselves intensified market fears and concerns, forming a vicious cycle in which adverse market sentiment drives down reserves via foreign-exchange market intervention, and the decline in reserves, in turn, further dampens market sentiment. The timing of market movements suggests that the Bank of Korea’s three swap agreements, in particular the agreement with the US Fed, played a pivotal role in calming down the growing market hysteria over a possible dollar shortage.
Taxes on capital inflows might provide a better alternative, the authors suggest.
since financial instability in emerging markets is usually the result of volatile capital flows and the fundamental purpose of precautionary reserves is to limit financial instability, some emerging markets may opt to dampen the precautionary accumulation of foreign-exchange reserves by controlling volatile capital flows. According to this argument, controlled financial integration, which retains some restrictions on capital flows, may limit financial instability. This, in turn, will limit the need for precautionary foreign-exchange reserves.
One possible solution to sudden stops and de-leveraging may be a Pigovian tax scheme, where inflows of portfolio flows and external borrowing above a threshold may be taxed at an increasing rate, reflecting the resultant higher exposure of the central bank to possible future bailout of the banking system.2 Such a tax scheme, implemented before the inflow of foreign funds takes place, may curtail exposure to the growing hazard facing the recipient country due to possible de leveraging (see Aizenman 2009). It may induce the foreign investor to internalise the externality associated with possible costs of de-leveraging, and would reduce the cost of self insurance.