Federal Reserve urged to consider bringing back 2008-era dollar swap lines
Gillian Tett
The New York branch of the Fed has been offering loans in the repo market © Justin Lane/EPA/Shutterstock
How badly will the coronavirus pandemic hurt global trade flows?
That is a question many investors are nervously asking, as countries including the US and India impose travel bans and companies everywhere brace for supply-chain shocks.
But as fear spreads, there is a second issue that investors should also contemplate: what will happen to the financial flows that normally back these supply chains?
The answer may be alarming.
As Credit Suisse analysts point out, these issues could create big dislocations in demands for dollar funding. The US Federal Reserve can try to offset the impact by intervening dramatically in its domestic repurchase “repo” markets — as it did on Wednesday and undoubtedly will do again — that may not be enough to offset all the global stress.
“Our main concern is about missed payments for dollars globally,” the analysts wrote, adding that missed payments will force “firms to become deficit agents [consuming more money than they generate]; as this cascades, banks and regional banking systems will become deficit agents [too].
”Predicting how this might play out is fiendishly hard because these trade financing flows are almost as complex as manufacturing supply chains — and as lamentably opaque as the shadow banking world was before 2007.
Nevertheless, the Bank for International Settlements surveyed the landscape in 2014, in what shockingly seems to be the last serious study. It made four points that matter now.
First, the bank-intermediated trade finance sector is large, between $6.5tn and $8tn.
Second, more than a third of it, around $2.8tn, occurs via letters of credit from banks. These borrowing lines are typically not recorded on the banks’ books unless or until the client activates them.
That, unnervingly, means “for the most part, L/Cs represent off-balance sheet commitments”, the BIS wrote.
Third, since most global trade is invoiced in dollars, more than 80 per cent of L/Cs are settled in them as well. The BIS says, “a key condition for the ability of many banks to provide trade finance is their access to US dollar funding”.
Fourth, dollar access is uneven. US banks can tap the Fed’s financing tools and big players can cut deals in the repo markets. But only a quarter of trade finance comes from major international banks, so much of the funding goes through intermediaries.
Thus far, these financing chains do not seem to be too stressed. It has become markedly more expensive recently to raise dollars from yen-based markets. This matters because Japanese banks became the dominant non-US provider of dollars after European banks retreated.
Thankfully this swing is still modest compared to 2008. However, that may just reflect a time lag. Credit Suisse notes that when trade is disrupted, companies initially need less funding, not more, as they use the stocks they have on hand.
But after a few weeks, payments start getting missed and create a dash for funding. Regional banking systems may be ill-prepared, since they typically assume that letters of credit will only be tapped in an idiosyncratic, not systemic, way.
There are ways for the Fed to offset this. It can pour liquidity into the US repo market, and hope it trickles out. It can also make dollars available to other central banks, so they can support their own private sectors.
The Fed did exactly that back in 2008 by cutting swaps deals with its counterparts in Canada, UK, Switzerland, Japan and the EU. Pierre Ortlieb, economist at the Official Monetary and Financial Institutions Forum, argues that the pandemic means US policymakers “should bring back dollar swap lines”.
It is unclear how President Donald Trump would react if the Fed did so. “Is the White House going to demand a quid pro quo from places like Europe or Japan” for the swap lines, frets a former central banker who helped cut the 2008 deals. In addition, the central bankers involved in those talks have mostly left. Jay Powell, Fed chair, is forging commendably collaborative relations, but they are not battle tested — yet.
More worrying, the 2008 swaps deals did not include China or Taiwan. But today, Chinese companies and banks have big dollar needs. And Taiwanese life assurance companies have large foreign exchange exposures through the country’s role in the semiconductor industry, as Brad Setser of the Council on Foreign Relations notes.
The key point is this: what the Fed does next with interest rates matters; but what it does with repo markets and central bank swaps matters even more.
As in 2008, it pays to watch the financial plumbing, even if its twists and turns are once again fiendishly hard to track.
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