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Tuesday February 3, 2009 - 18:52:27 GMT
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Forex Blog - Low Risk FX Swaps No End to Fed...Barron's: Europe's Growing Crisis Puts the Fed at Risk

Low Risk FX Swaps No End to Fed...Barron's: Europe's Growing Crisis Puts the Fed at Risk


I am as interested in the next shoe dropping on the global financial system as the next person.  But raising currency swaps between the Fed and ECB (and other foreign central banks) as the latest FWMD (financial weapon of mass destruction) is absurd. 


When the Fed arranged vastly larger FX swap lines with the world’s central banks in 2008 it was not signing away vast sums of US dollars into a black hole of bank insolvency as one might conclude from reading the Barron’s article this weekend (attached below).  First of all the Fed got euros for USD in the swaps from the ECB (and GBP from BOE, SEK from Riksbank, and NOK from Norges Bank, and DKR from Danmarks National Bank and CHF from SNB, and CAD from BOC, and JPY from BOJ…).   The article describes the facility as a loan from the Fed to European banks via central banks.  But the swap is also a loan of euros to the Fed by the ECB.  I would view even large FX swaps among G20 central banks as about as risk free as any financial arrangement and would not consider it a loan.  The swap lines were put into place to relieve a shortage of USD in the global banking system as banks moved to hoard dollars in light of a loss of confidence in the bank system’s solvency.  Before the swaps were arranged, banks were buying USD in the open market and driving the greenback sharply higher (interbank swap and forward market shut for anything beyond one-week money).


Sure the foreign central banks take on risk when they lend these dollars to local banks – they may not get repaid.  However, the notion of banks not repaying central banks for liquidity is as much a risk for the ECB as it is for the Fed and we are now in a world where too big to fail is the operating instruction guiding liquidity provisions to the banking system.  No bank will be allowed to default to other banks, bond holders and central banks. 


But it is also noteworthy to view foreign central banks as having USD reserves which could be used to swap back with the Fed for local currencies in the event the local banking systems froze and failed to repay dollars borrowed from central banks across the planet. 


The article also confuses an FX swap (no currency risk as exchange rate is fixed) with spot exchange (comes with FX risk).   


And the article seems to be based on the assumption that any move by a major central bank to print money (the ECB for instance in the event of not receiving dollars back from banks could use unsterilized intervention to buy dollars for euros to repay the Fed on swap line plus or minus the difference between the FX rate of the swap) is the end of a currency and bond market.  Monetization is no panacea for bank solvency and deflation.  Moreover it is not a guarantee of hyperinflation and currency devaluations assuming it ends quickly and is just as quickly reversed. 


Perhaps European banks are way behind in writing down assets (MTM accounting) and are considerably more leveraged than US banks.  But this future adjustment and dislocation is hardly the basis for expecting the Fed to take huge hits on currency swaps with foreign central banks.


Where would euro/dollar be without Fed swap lines?  We may never know, but I suspect these swap lines were very effective shadow currency intervention (not its main purpose – liquidity was) and the Barron’s article is off the mark by miles.


David Gilmore


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