The Guardians of the Financial Galaxy

The rapid expansion of the pandemic and the ensuing economic and financial collapses brought about responses by policymakers, including actions undertaken on an international basis. The Federal Reserve acted together with other central banks to ensure that an adequate supply of dollars was available to support dollar-based financing outside the U.S. Similarly, the IMF moved rapidly to provide financial support to its members. These national and international institutions constitute a “two tier” system in international finance that occupies the role of lender of last resort.

International cooperation has occurred before, and Michael Bordo of Rutgers University gives an account of these efforts in a new NBER working paper, “Monetary Policy Coordination an Global Financial Crises in Historical Perspective.” During the Bretton Woods era, central banks cooperated to sustain the fixed exchange rate system. In 1962, the U.S. established bilateral currency swaps with foreign central banks, which provided dollars to be used in support of their exchange rates.

The swaps continued in the 1970s after the termination of the Bretton Woods regime as policymakers sought to control the volatility of exchange rates. During the early and mid-1980s there were episodes of coordination of foreign exchange market intervention by central banks as governments in the advanced economies sought to stabilize the value of the dollar. But these occurred less frequently in the late 1980s as inflation fell in most of these countries and foreign exchange market intervention became less common.

The outbreak of crises in emerging markets in the 1990s required a joint response, and the IMF took on the role of crisis manager. During the Asian crisis of 1997-98, for example, the Fund provided credit to the governments of the countries in crisis. Their programs included conditions that required included cutbacks in government spending and credit creation, and frequently a currency devaluation. However, the IMF’s policies came under immediate criticism as inappropriate and overly severe. These were not crises based on excessive government spending, but rather financial collapses. The IMF paid a high price in its reputation for its handling of the Asian crisis, but learned a valuable lesson: financial instability can impose a serious cost.

The financial crisis of 2007-09 provided another major challenge to global financial stability and the need for a coordinated response. Banks in Europe and Japan had borrowed dollars to acquire dollar-denominated assets, such as mortgage-based securities. Their access to dollar funding was threatened as the interbank markets for dollars came under strain. In December of 2007, the Federal Reserve announced that it was establishing swap lines with the European Central Bank and the Swiss National Bank. At the crisis escalated in 2008, the Federal Reserve set up similar arrangements with the central banks of Australia, Canada, Denmark, England, Japan, New Zealand, Norway, and Sweden. It also arranged swap arrangements with the central banks of Brazil, Mexico, Korea and Singapore, emerging market economies with substantial exposure to dollar-based financing. The Federal Reserve and the foreign central banks exchanged currencies, and the foreign central banks lent the dollars to its domestic banks that needed them. At the conclusion of the swap period, the currency exchanges were reversed using the same exchange rate, and the central banks would pay the Fed a fee based on what it had charged their own banks.

These arrangements differed from previous efforts in that they were designed to address financial instability, not exchange rate values. The dollar had become the primary global funding currency, so a decrease in dollar liquidity would have had widespread effects. The joint activities of the Federal Reserve and its partner central banks were successful in bringing down the cost of dollar lending in the foreign markets and avoiding the collapse of foreign institutions with dollar liabilities.

The IMF was also active during the crisis. Not all central banks were able to exchange currencies with the Federal Reserve, and the IMF served as an alternative source of financing. During the period from September 2008 through the following summer, the IMF instituted 17 Stand-By Arrangements. The economic policies that were part of these programs reflected an awareness of the origin and severity of the global downturn. Credit was disbursed more quickly and in larger amounts than had occurred in the past and there were fewer conditions attached to the programs. Consequently, the IMF’s record during the great recession was very different from that of the Asian financial crisis.

During the current crisis, central banks and the IMF have built upon and expanded the policies they undertook in 2008-09. Once again, global dollar financing came under strain. In March the Federal Reserve renewed or set up swap facilities with the central banks of 14 countries. In addition, it established a repurchase facility for foreign and international monetary authorities (FIMA) that would allow them to temporarily exchange their holdings of U.S. Treasury securities for dollars.

These efforts were successful in preventing a collapse of dollar financing. Nicola Cetorelli, Linda S. Goldberg and Fabiola Ravazzolo of the Federal Reserve Bank of New York investigated the impact of the Federal Reserve’s facilities by comparing the foreign exchange swap basis spreads of currencies covered by the agreements with those on other currencies. They found that  ”… the swap lines have been an important factor helping to improve market conditions and expand access to dollar liquidity during the period of peak strains in global U.S. dollar funding markets.” They added that the Federal Reserve was engaging in a wide range of other actions that could also have impacted this market.

The central banks that obtained the dollars were able to use them to support banks that provided dollars to other parties in their countries. For example, Gianluca Persi of the European Central Bank showed that the Eurosystems’s use of the swap lines”…not only helped banks to satisfy their immediate U.S. dollar funding needs but also supported market activity.” He concludes that “The swap lines between central banks therefore helped to mitigate the effects of the strains in the U.S. dollar funding market.”

The IMF has also been active in meeting the needs of its members. The IMF has used its rapid financial assistance programs (Rapid Financing Instrument, Rapid Credit Facility) to make loans to 76 countries. These loans do not require full programs or reviews, and carry little conditionality. The IMF is also adjusting existing programs to meet the need for health-related expenditures.

The IMF is making special efforts for its low-income members. It is providing grants to its poorest members to cover the IMF debt obligations. In March the IMF and World Bank called on official bilateral creditors to suspend debt service payments from low-income countries. The Group of 20 governments responded by agreeing to suspend repayment of official bilateral credit from these nations until the end of 2020. The IMF, the World Bank and the G20 also called for private sector creditors to participate in similar debt relief on comparable terms.

IMF Managing Director Kristalina Georgieva at the opening of this spring’s meeting pledged to use the Fund’s  $1 trillion lending capacity to support its members. She also urged governments to be active in addressing the needs of their citizens. In a speech at the London School of Economics on October 6, she pointed out that “flexible and forward-leaning fiscal policy will be critical for the recovery to take hold.” She also called for measures to deal with the debt of low-income countries, including “access to more grants, concessional credit and debt relief, combined with better debt management and transparency.”

A division of labor, therefore, has evolved between the Federal Reserve and the IMF during periods of widespread instability. The Federal Reserve provides dollars to other central banks in upper-income countries and selected emerging market economies to preserve stability in the global financial markets. Since the Federal Reserve lends to central banks, there is little concern about insolvency. In many ways it assumes the traditional role of lender of last resort as conceived by Bagehot and other nineteenth century economists.

In normal times the IMF lends to governments in middle- and low-income countries with balance of payments crises and possible insolvency. The Fund disburses credit in programs that operate over a time horizon at least a year and sometimes longer. However, during the global financial crisis and now the current crisis, the IMF ramps up its lending. It provides credit quickly at little if any cost, and its programs seek to stabilize economic activity. Moreover, the IMF takes public positions to advocate fiscal stimulus and debt relief.

Stanley Fischer, who served as First Deputy Managing Director of the IMF from 1994 to 2001, saw the need for an international lender of last resort for countries facing an external financial crisis, and claimed that the IMF had played that role in the 1980s and 1990s. In subsequent years it became clear that central bankers in advanced economies preferred to deal with each other and organize their own programs. There have been periodic calls for the IMF to become more involved in swap networks, but the central banks have shown no interest in involving the IMF in their networks. The two-tier system functioned relatively well in 2008-09 and to date has stabilized financial markets. But the number of coronavirus cases are surging, and there are concerns about another recession in the U.S. and Europe. The current system to back stop financial markets and institutions will be tested in new ways that may show its limitations.