The US as ‘Sovereign International Last-Resort Lender’: The Fed's Currency Swap Programme during the Great Panic of 2007–09

Abstract

Beginning in late-2007 and culminating in autumn 2008, the US Federal Reserve took extraordinary action to address global dollar scarcity through the provision of dollar swap lines with a total of 14 foreign central banks. At their peak, these emergency credit lines provided nearly $600 billion in financing to economies starved of dollars. This case represents an archetypal example of ‘sovereign international last-resort lending’. The article explores this case in order to engage the following two questions. First, what criteria qualify a state to play the role of international lender of last resort (ILOLR)? Second, under what conditions will a state with the capacity to act choose to do so? The article argues that the primary factor from which states derive the capacity to act as ILOLR is the international status of their national currency. Additionally, it contends that states with the capacity to act as ILOLR do so for defensive reasons. Examining the Fed's swap programme, three spillover effects are identified that threatened the US economy and motivated the US central bank to engage in defensive international last-resort lending during the crisis: financial system exposure, interest rate concerns, and a dramatic appreciation in the dollar's exchange rate.

Keywords:

• financial crises
• international lender of last resort
• central banking
• Federal Reserve
• hegemony
• currency

Acknowledgements

The author would like to acknowledge Benjamin J. Cohen, David Leblang, Jeffrey Legro and Herman Schwartz for their helpful comments on this manuscript.

Notes

In May 2010, the Fed reopened four unlimited swap lines with the ECB, BOE, SNB, BOJ, and BOC.

In fact, Japan did extend a yen–won bilateral swap arrangement ($20 billion equivalent) to South Korea in December 2008.

Norway, Sweden, and Denmark each extended ‘euro–króna’ swaps (€500 million each) with Iceland in 2008.

These examples are not always about last-resort lending per se, but rather state involvement within the broader concept of ‘crisis management’. Nonetheless, these accounts represent the closest attempt to identify the conditions whereby states will engage in international last-resort lending.

Baba et al. (2009) say that these 15 prime funds account for about 40 per cent of the total prime funds' assets, meaning that the numbers would increase if the other 60 per cent were accounted for.

It is worth noting the resources available to these foreign central banks in the form of their own dollar reserves since, obviously, one way of filling the ‘dollar gap’ would be to supplement it with one's own war chest. McGuire and von Peter (2009, p. 20) estimate that in mid-2007, the euro area, SNB, and BOE had a combined total of $294 billion, a total far smaller than their lower-bound estimate of the dollar funding gap. At least in these cases, there weren't enough dollars to go around. The emerging market economies, conversely, seem to have had ample dollar reserves. According to Obstfeld et al. (2009, p. 8) Korea had $260 billion, Singapore $162 billion, and Brazil had $180 billion. However, given that each of these economies were facing depreciating currencies during the crisis, the possibility existed that using their own reserves would have led to a speculative run on the currency (Krugman 1979) perhaps motivating the $30 billion swaps.

A circumstance when the net asset value of a money market fund drops below $1.

Commercial paper is a promissory note with a fixed maturity between one and 270 days. ABCP is a collateralised form, meaning that the issuer provides another asset to guarantee the debt.

Ultimately, the €3.5 billion in loans and €8 billion in guarantees to IKB was not enough as the bank eventually defaulted on $7 billion in debt and was sold off to a US private equity firm (Schwartz 2009b, p. xiii). Sachsen was initially given a €17.3 billion credit line but was soon bought out by German bank LBBW and subsequently merged and dissolved.

Other indices include the one-year constant-maturity Treasury yield, the Eleventh District Cost-of-Funds Index, and the Federal Housing Finance Board national average contract interest rate.