A Solution to Sudden Stops
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- Authors: Ricardo Reis
- Published: June 1, 2019
The IMF’s traditional role in sudden stops
- A major function of the IMF is to provide short-term loans to countries that experience a sudden stop in the inflow of private capital.
- Left on their own, countries facing sudden stops can experience:
- a sharp depreciation of their exchange rates,
- large recessions,
- likely default on their foreign debt.
- Insurance against sudden stops is valuable to:
- smooth the outflow of capital over time,
- prevent “fire sales” (the sale of assets at prices far below their market value),
- limit contagion.
- Since the 1944 Bretton Woods conference, the causes, features, and consequences of sudden stops have changed, but the IMF’s role as lender of last resort has endured.
Bank sudden stops and central bank lender-of-last-resort role
- Banks suffer a different sort of sudden stop when they lose access to short-term funding needed to finance long-term investments; in this situation they turn to their central bank.
- In 2007, when US dollar money markets froze, some banks outside the United States experienced a sudden stop driven by frozen dollar funding markets.
- The Federal Reserve provided a solution by opening dollar swap lines with central banks in selected countries:
- the Fed lent dollars to those central banks;
- those central banks lent dollars to their domestic banks to fund US dollar investments.
- Rationale and mechanics:
- The Fed could provide US dollar funding and prevent fire sales of dollar assets.
- Domestic central banks, which regulate banks and can assess solvency and collateral, provided funding through their lending facilities and bore the credit risk.
- The Fed held the other countries’ currency and bore almost no risk; if repayment occurred, that currency would never enter circulation.
Evidence of effectiveness of swap lines
- Two complementary assessments:
- Central bank lending facilities should cap private lending rates and lower the average market rate.
- Banks with access to a central bank swap line should be relatively more willing to invest in US dollar financial assets.
- Empirical observations:
- US dollar swap lines significantly lowered a currency’s basis to the dollar relative to currencies without a swap line.
- 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 central bank swap lines and IMF lending
- Central banks can:
- create money quickly,
- assess the solvency of banks,
- judge the quality of collateral.
- Swap lines versus IMF loans:
- Swap lines are not loans to governments and do not monetize public debt.
- Swap lines use collateral rather than conditionality as the incentive.
- Swap lines lead to conventional credit risk for the recipient central bank but little risk for the originator central bank.
- IMF loans are fiscal instruments and address government finances when problems are persistent or involve insolvency.
Why the IMF and central bank roles are converging
- Three reasons the distinction will likely be less clear in the future:
1. Capital flows are often intermediated by banks, so a run on a country often begins with a run on its banks.
- The diabolic loop: when banks hold a large amount of their government’s bonds, the solvency of both becomes intertwined.
- Central bank swap lines may be used initially, but the IMF may be called later; timing becomes the main distinction (example: the euro crisis of 2010–12).
2. Central bank facilities are designed for short-term liquidity problems and require transition to fiscal operations if problems persist.
- When banks cannot repay central banks for a prolonged period, fiscal authorities arrange bailout packages that shift the problem to government finances—the IMF’s purview.
3. The number and types of central bank swap lines have grown quickly:
- Roughly three types of arrangements today:
- Type I: bank-focused (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 where large financial centers facilitate 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.
- Type III swap lines closely complement or substitute for IMF actions but are bilateral, up for frequent renewal, and subject to discretionary political choices, so they can conceivably be withdrawn when needed.
Policy implications and potential IMF roles
- The IMF could play a role in future swap lines and in promoting multilateralism:
- The Fed has only five standing Type I swap lines, all with advanced economies, leaving many central banks—especially in emerging markets—without such access despite dollarization of their banks and exports.
- Advanced-economy central banks worry that swap lines may not be honored by recipient central banks and that foreign currency held could be worth less if exchange rates are very volatile.
- The IMF is well placed to:
- assess recipient-country risk,
- choose the margin to apply to the current exchange rate,
- underwrite swap contracts so the originator central bank would bear no risk.
- If the recipient central bank and its government default, the IMF could control:
- how much domestic currency enters circulation,
- the amount of IMF lending,
- how much IMF capital is put at risk.
- Concluding assessment:
- IMF lending and central bank swap lines are very different instruments, but the IMF could complement central bank swap lines to support global financial stability.
Source: Ricardo Reis, F&D Magazine, June 2019.
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