## The IMF and central banks should work together to resolve financial crises

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### The IMF’s traditional role in sudden stops
- The IMF provides short-term loans to countries that experience a sudden stop in the inflow of private capital.
- Since the 1944 Bretton Woods conference, the IMF’s role as lender of last resort has endured despite changing causes, features, and consequences of sudden stops.
- Purpose of IMF insurance:
  - smooth the outflow of capital over time,
  - prevent “fire sales” (the sale of assets at prices far below their market value),
  - limit contagion.

### Central banks as lenders of last resort for banks
- Banks experience sudden stops when they lose access to short-term funding needed to finance long-term investments; central banks serve as their lender of last resort.
- Central banks can create money quickly, assess bank solvency, and judge collateral quality—capabilities distinct from the IMF.

### The merging of country and bank sudden stops
- Increasing global intermediation by banks has caused the two types of sudden stops to merge; banks borrow in foreign currencies to invest abroad.
- 2007: US dollar money markets froze, causing banks outside the United States to experience a sudden stop tied to US dollars.
- Central bank swap lines were used to address these strains by converting domestic currency into foreign currency.

### How US dollar swap lines worked in practice
- The Federal Reserve opened dollar swap lines with selected central banks.
- Mechanism:
  - The Fed lent dollars to recipient central banks.
  - Those central banks lent dollars to their domestic banks to fund US dollar investments.
  - Domestic central banks assessed solvency, provided funding, and bore credit risk; the Fed held other countries’ currency and bore almost no risk.
  - If repayment was made (as it always was), the foreign currency held by the Fed would never enter circulation.

### Assessing the effectiveness of central bank swap lines
- Two complementary metrics of effectiveness:
  - Central bank lending facilities should cap rates charged by private lenders and lower average market rates. Evidence: US dollar swap lines significantly lowered a currency’s basis to the dollar relative to currencies without a swap line.
  - Access to swap lines should make banks more willing to invest in US dollar assets, knowing a lender of last resort is available. Evidence: after the rate charged on US dollar swap lines fell by 50 basis points in 2011, financial institutions trading in Europe significantly shifted their investments to US dollar bonds.

### Differences between swap lines and IMF loans
- Swap lines:
  - Are loans of last resort in the domain of central banks.
  - Use collateral rather than conditionality as incentive.
  - Lead to conventional credit risk for the recipient central bank but little risk for the originator central bank.
  - Are not loans to governments and do not monetize public debt.
- IMF loans:
  - Are fiscal instruments addressing sovereign balance-sheet issues and conditionality.

### Reasons the roles of IMF and central banks will blur
- First: Capital flows are often intermediated by banks, so a run on a country can begin with a run on its banks; the diabolic loop (banks holding large amounts of their government’s bonds) intertwines solvency of banks and governments. Central bank swap lines may be used first, but the IMF is often called later; timing becomes the main distinction. Example: the euro crisis of 2010–12—initially triggered TARGET II balances between euro area central banks, then required IMF lending.
- Second: Central bank lending facilities target short-term liquidity problems and require a transition to fiscal operations if problems persist. When lending recipients turn out to be insolvent rather than illiquid, the problem becomes fiscal and falls within the IMF’s purview.
- Third: The number of central bank swap lines has grown quickly; three types are identified:
  - Type I: bank-focused arrangements (as described above).
  - Type II: arrangements such as those between the People’s Bank of China and central banks in countries with significant Chinese investment or large financial centers facilitating bilateral trade settlements.
  - Type III: arrangements such as the Chiang Mai Initiative and the European Central Bank’s Exchange Rate Mechanism II, which pool foreign reserves or support confidence in exchange rate pegs; these closely complement or substitute for IMF actions but are bilateral, up for frequent renewal, and subject to discretionary political choices.

### The IMF’s potential role in future swap lines and multilateralism
- Rationale for IMF involvement:
  - The Fed has only five standing Type I swap lines, all with advanced economies, while many other central banks—especially in emerging markets—would benefit given dollarization of their banks and exports.
  - Advanced economy central banks worry that swap lines may not be honored by recipient central banks and that the foreign currency held could be worth less if the exchange rate is very volatile.
  - The IMF is positioned to assess this risk, choose the margin to apply to the current exchange rate, and underwrite these contracts.
- Proposed allocation of risk and roles:
  - The originator central bank would bear no risk if the IMF underwrites the arrangement.
  - If the recipient central bank and its government default, the IMF would control how much domestic currency enters circulation, the amount of IMF lending, and how much IMF capital is put at risk.
- Conclusion: IMF lending and central bank swap lines are very different instruments, but the IMF could play a role in swap lines to complement IMF lending and promote multilateral solutions.

*Ricardo Reis; June 2019, Finance & Development*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2019/june/imf-and-central-banks-working-together-reis.pdf_