VoxEU Column COVID-19 Development

COVID, Fed swaps and the IMF as lender of last resort

31 Mar 2020

Dollar shortages and the real consequences of the COVID pandemic may lead to the next wave of emerging market debt crises. This column argues that Fed swaps mitigate this shortage only for a few selected countries, and traditional international financial institutions’ products are ill-designed to assist an emerging market facing a sudden stop. As a broker between central banks and emerging economies, the IMF has a unique opportunity to complete the international financial architecture and fill the lender of last resort role that has long eluded it.

Eduardo Levy Yeyati

Dean, School of Government Torcuato di Tella University

Amid escalating concerns about the real implications of the COVID pandemic (Baldwin and Weder di Mauro 2020), emerging markets (EMs) are, once again, in the line of fire. While developed countries can – and should –fund massive fiscal stimuli by issuing debt at interest rates close to zero, EMs are at the short end of the flight to quality: they face a sudden stop, widening of credit spreads and mounting exchange rate pressure; in addition to the generalized decline in global demand and, in most cases, terms of trade.

Analysts are arguing that ‘this time is truly different’ (Reinhart 2020) and that the situation demands a whatever-it-takes approach to avoid the next EM debt crisis (Ghosh 2020), including through exceptional dollar liquidity facilities (Lowery 2020). However, ten years after the global financial crisis intensified the debate about how the international financial architecture could mitigate global dollar shortages due to a systemic flight to quality, we are still left with the few, insufficient instruments used back then. Can we overcome this shortcoming and bring badly needed dollar lines to troubled emerging economies? Yes, in a scheme where the IMF works as an independent broker that manages existing central bank swap agreements into one big hard currency liquidity network.

At a time when investors have pulled out more than $42 billion from emerging markets, the largest outflow ever recorded according to the Institute for International Finance, the Fed has activated its dollar-swap lines with central banks of just a few economies, temporarily including only four emerging markets, as in 2009. In addition, the IMF has offered to mobilize its $1 trillion emergency lending capacity through its flexible and rapid-disbursing emergency response facilities (Georgieva 2020). These, however, are again limited to only a few economies which are in good standing with the IMF and are sure to benefit from the assistance, but exclude those likely to need it the most.

As financially integrated economies are suffering from a brutal sudden stop in capital flows and extreme exchange rate volatility, access to foreign currency liquidity is again essential to prevent the health crisis from developing into an economic depression.

What can be done? One option would be to broaden access to the dollar (and other hard currency) swap lines, so as to redistribute liquidity more efficiently in times of massive one sided fly-to-quality flows to a few issuers of reserve assets. This could be done, for example, by adding countries to the aforementioned Fed list. However, there are good reasons to expect the Fed to continue to be selective: its goal is not to assist countries in distress, but rather to ensure that a there is sufficient dollar liquidity to contain an excess increase in dollar strength abroad that could deepen the contraction at home. This explains the selection of ‘systemically important’ emerging economies with deep currency markets as the choice recipients of the swaps.

An alternative, more natural option to enhance access to central bank swaps would be to use the IMF as a bridge– money broker + credit risk assessor + risk retainer– between the Fed and other central banks. This would be similar to the role played by the Fund today with the Treasuries of advanced countries, but in a format more functional to the treatment of liquidity crises: fast, large, and frontloaded. In other words, the IMF would act as a true international lender of last resort (LLR).

The missing link

A global LLR, the missing link in the international financial architecture, is qualitatively different from a network of central bank swaps, in that it should be broadly available on demand, rather than selectively at the lender´s discretion. In turn, it is also different from traditional self-insurance wherein the central bank acts as the domestic LLR of the banking sector, since, in the presence of a global LLR, the central bank does not need to hoard liquidity during good times.

Note that, ultimately, the missing LLR problem is not about the IMF. In the event of a global risk, only the issuers of last resort (Fernández‐Arias and Levy‐Yeyati 2012) — countries that can issue reserve assets to attract liquidity in bad times — can retain the systemic liquidity risk in good times without a hefty carrying cost. This logic underscores the role play by the US Fed swaps during the crises. In such global risk events, all but the issuers of last resort are likely to face dollar shortages at the same time, and hence, risk pooling and diversification do not work well against systemic shocks. Thus, it is not the (very minor) diversification margin from centralized reserve management, but rather the access to liquidity on demand that makes the international LLR (and, in particular, the scheme proposed here) far more efficient than individual self-insurance or regional reserve pools.

How can these issuers of last resort provide liquidity to the rest of the world when needed? One option is, of course, to increase the IMF capital, which, while a welcome addition, may take long to materialize and would likely be channeled through the existing facilities.

Alternatively, one could think of the IMF as an independent broker (Levy Yeyati and Cordella 2010) that manages existing central bank swaps into one big liquidity network for a longer list of eligible countries, standing ready to step in with the traditional IMF toolkit program if needed. Under the proposed arrangement, the IMF would be the dealer between the funding central bank and the borrowing country, much in the same way as it currently manages the contingent funds of the agreements to borrow. Thus, perhaps it is as a ‘central bank swap clearing house’ that the IMF can finally move closer to the international LLR role that it has been aiming for.

Such a scheme begs a critical but often overlooked question at the core of the global safety net shortcomings: are the issuers of last resort (the Fed, the Bank of Japan, the ECB, the BoJ) willing to play this role? Or, more to the point, to let the IMF do so on their behalf? To what extent and under what conditions would these countries provide liquidity to the rest of the world when needed?

Ultimately, the debate about the financial architecture has been and still is less about credit risk than it is about politics. It involves the political will of a few players with the key to promote global financial stability in a broader and less discretionary way. Once again, a crisis is testing whether the international community is ready to pay the price.