Central bank swap and repo lines have been used extensively in the last decade to provide liquidity in foreign exchange markets during periods of distress (e.g. McCauley and Schenk 2020, Aizenman et al. 2021). During the Covid-19 pandemic, central bank coordination has played a key role in temporarily preventing financial market turmoil from morphing into global financial instability (IMF 2020).
The functioning of liquidity lines is straightforward. When a liquidity line is active between a source central bank and a recipient one, the latter can access the source central bank’s currency in exchange for its domestic currency at the spot exchange rate and at a fixed interest rate, which is below the market rate. At maturity, the same amount of money is exchanged among the two counterparties at the same fixed spot exchange rate. In this ‘do ut des’ agreement, on the one hand, the recipient central bank can inject liquidity in the domestic market, preventing market pressure on its own currency in times of financial stress or to avoid exhausting its own reserves. On the other hand, by reducing foreign liquidity shortage, the source central bank prevents negative spillovers in the form of financial instability (McCauley and Schenk 2020, ECB 2021).
In this context, previous contributions have extensively focused on the Fed liquidity lines and its role of international lender of last resort, but what do we know about those of the ECB? What is the scope and effectiveness of these lines? In this column, we present descriptive and empirical evidence (based on Albrizio et al. 2021) on the ECB agreements providing euro liquidity.
Since the 11 September 2001 terrorist attack, the ECB has participated in the network of G10 central banks contributing to provide dollar liquidity globally.1 In addition, between October 2008 and August 2020 it established and/or extended a total of 28 swap and repo lines with 16 foreign counterparts to provide liquidity in euro.
Figure 1 Timeline of the ECB swap and repo lines announcements providing euros and liquidity in other currencies
Source: Albrizio et al. (2021). Database based on ECB press releases available online here.
Note: The figure reports the announcements of ECB liquidity facilities. Above the timeline, establishments of lines between the ECB and other central banks for the provision of foreign currencies (such as US dollar, British pound, Swiss franc, Chinese yuan) are reported. Below the timeline, ECB euro liquidity facilities are recorded.
Historically central banks’ liquidity lines have been used for three main objectives: (1) defending a peg system such as Bretton Woods (Bordo et al. 2015, McCauley and Schenk 2020); (2) offering a global liquidity backstop, which is the case of the Fed (Auer and Kraenzlin 2009, Bahaj and Reis 2018); or (3) enhancing the international use of the domestic currency, specifically the case of People’s Bank of China (Bahaj and Reis 2020). As can clearly be made out from Figure 1, the main purpose of ECB liquidity euro lines so far has been to provide liquidity in times of distress, since the number of these announcements increased during crisis episodes.
Except for the agreements within the G10 network, counterparts in euro liquidity facilities have been mostly EU countries outside the euro area (Bulgaria, Croatia, Czech Republic, Denmark, Hungary, Poland, Romania, and Sweden). Moreover, since 20 March 2020, the ECB expanded the network to non-EU countries (Serbia, San Marino, Albania, and Republic of North Macedonia). Therefore, in contrast with the Fed, the ECB role has been more of a regional lender of last resort than a global one (Figure 2).2
Figure 2 Geographical distribution of ECB euro liquidity facilities: Repo and swap lines
Source: Albrizio et al. 2021.
Note: Countries whose central bank has established euro swap lines with the ECB are highlighted in red while countries with euro repo lines are highlighted in blue.
Direct effects of ECB liquidity lines: The reduction of foreign exchange borrowing costs
As highlighted in Auer and Kraenzlin (2009), during market turmoil interbank money markets may not function smoothly. In times of financial stress, it is increasingly expensive for agents to borrow in the riskier foreign exchange markets making it harder for banks and firms to fulfil foreign currency-denominated contracts and liabilities. Previous empirical research shows that the Fed swap lines have been effective in lowering dollar borrowing costs (Bahaj and Reis 2018), limiting asset fire sales, and helping contain the risk of market contagion. Moreover, the mere announcement of the Fed facilities gave confidence to market participants without the need for activating them (Panetta and Schnabel 2020), the so-called signalling effect (Aizenman et al. 2021).
Similarly, we compare changes in the euro funding cost in foreign exchange markets of targeted currencies with those of currencies of similar non-targeted countries.3 To isolate the signalling effect, we estimate these changes in a narrow window around the public announcement of each liquidity line.4 Figure 3 compares the density of these changes for targeted and non-targeted currencies. The distribution for targeted countries suggests a shift to the left towards lower euro borrowing costs. In contrast, we do not observe such shift in the non-targeted group. This suggests that ECB liquidity line announcements indeed were effective in decreasing euro funding costs in targeted economies.
Figure 3 Foreign exchange basis density before and after announcement
Source: Albrizio et al. 2021.
Note: Foreign exchange basis density in a four-day window around the announcement. For any announcement, the treated currency/ies is/are going to be the one/s targeted by the announcement, while the non-targeted currencies in the sample are untreated. Post-treatment is defined as the day of treatment and the day after (Post), while pre-treatment is the two days prior to treatment (Pre).
In a more formal assessment, relying on a difference-in differences approach as in Bahaj and Reis (2018), we estimate that the announcement of a swap line reduces the euro funding cost in foreign exchange markets significantly and up to 76 basis points (Figure 4).
Figure 4 Estimated reduction in the foreign exchange euro funding cost: Signalling effect
Sources: Albrizio et al. (2021).
Note: The blue bars represent the estimated effect on the foreign exchange swap basis of treated currencies with respect to a group of currencies non-targeted by lines announcements. Sample I includes countries whose currencies have been targeted at least once during the time frame considered (Bulgaria, Denmark, Croatia, Hungary, Poland, Serbia, Sweden). Sample II adds currencies of geographically contiguous countries that have never been targeted (Norway, Iceland). Sample III expands Sample II by considering G10 countries targeted (US, Switzerland, Canada, UK, Japan) and additional control countries such as New Zealand and Singapore.
Indirect effects: Spillbacks to euro area banks
Liquidity shortage in foreign exchange markets may spill back to the domestic market under different forms: morphing into global financial instability, increasing financing cost for domestic firms (McCauley and Schenk 2020), or negatively affecting the market evaluation of domestic banks most exposed to the stressed markets. Central bank liquidity line announcements may prevent the materialisation of these negative spillbacks by instilling confidence in recipient economies and reducing the risk of contagion. Moreover, Fed lines have generated positive spillbacks, since cheaper swap lines increase purchases of dollar-denominated assets in banks located in targeted jurisdictions, relative to other banks and to other denominations (Bahaj and Reis 2018).
To assess the potential spillbacks to the euro area, we compare the equity price of banks in euro area countries with strong banking ties to the targeted countries versus banks in less exposed euro area countries. Therefore, we would expect that an ECB announcement of a repo line with Romania will benefit Italian more than Belgian banks, since the latter do not have strong banking linkages with Romania. Our results point to an increase of around 7% of bank equity prices of euro area countries more exposed to recipient economies when the announcement is made.
Conclusions: ECB lines work
Swap and repo lines are becoming an integral part of the ECB stabilisation toolkit. As stated in our work, their use turns the ECB into a regional lender of last resort since the ECB is increasingly relying on these instruments in time of crises. An unanswered question is then whether these arrangements can also boost the usage of the euro as an international currency, at least at the regional level (see Panetta and Schnabel 2020). Looking ahead, a broader and more permanent network may strengthen the global safety net and contribute to smooth the negative effect of capital flow reversals.
Albrizio, S, I Kataryniuk, L Molina and J L Schaefer (2021), “ECB Euro Liquidity Lines”, Banco de Espana Working Paper No. 2125.
Aizenman, J, H Ito and G K Pasricha (2021), “Central bank swaps in the age of Covid-19”, VoxEU.org, 08 April.
Auer, R and S Kraenzlin (2009), “Money market tensions and international liquidity provision during the crisis”, VoxEU.org, 14 October.
Bahaj, S and R Reis (2018), “Central bank swap lines”, VoxEU.org, 25 September.
Bahaj, S and R Reis (2020), “Jumpstarting an international currency”, VoxEU.org, 21 September.
Bordo, M D, O F Humpage and A J Schwartz (2015), “The evolution of the Federal Reserve swap lines since 1962”, IMF Economic Review 63(2): 353–372.
ECB (2021), “Central bank liquidity lines”, European Central Bank web article.
IMF (2020), Financial Stability Report, April 2020.
McCauley, R and C R Schenk (2020), “Swap innovation, then and now”, VoxEU.org, 12 April.
Panetta, F and I Schnabel (2020), “The provision of euro liquidity through the ECB’s swap and repo operations”, ECB blog, 19 August.