hankyoreh

The US dollar. (Reuters/Yonhap)

Currency swaps with foreign central banks may not be politically popular, but they could be essential in protecting the US economy, said Ben Bernanke, former chairperson of the US Federal Reserve.

As the won-to-dollar exchange rate continues to soar, a debate is raging over the issue of currency swaps. Analysts are also offering varying interpretations on the possibility of a South Korea-US currency swap line and the interests of the US, which has been taking the initiative in the situation.

Based on a closer examination of the 2008 global financial crisis and the 2020 COVID-19 pandemic, the Hankyoreh looked at the inner aims of the US Federal Reserve, which ultimately holds the key to any potential currency swap line agreement.

Currency swaps between countries are typically agreements between central banks to lend their currency to each other for a certain period. For example, if the Bank of Korea (BOK) and the US Federal Reserve sign a currency swap agreement, the BOK would lend won to the Fed and receive dollars in exchange.

The currency swap concept became familiar to the public through the 2008 South Korea-US currency swap line, which was concluded amid the global financial crisis.

Usually, currency swap agreements serve as a last resort emergency relief measure during a crisis, when dollars are running out in the domestic market.

But why should the Fed consider itself a kind of “financial savior” to other countries? In reality, a difficult situation was unfolding in the US during the 2008 global financial crisis.

France's BNP Paribas was the first among major global banks to suspend redemptions from investment funds related to the US subprime mortgage crisis in August 2007. A credit crunch ensued amid a growing sense of crisis over the subprime mortgage issue.

As doubts about creditworthiness spread among moneylenders, this led to a chill in the market where commercial banks lend money to each other.

A look at key indicators at the time clearly shows the crisis that had arisen.

For instance, the LIBOR-OIS spread (three-month), which shows the extent of the credit crunch in the dollar market, had consistently remained close to the zero percent mark, but in August 2007 it jumped to around one percent. This reflected a situation where it had become difficult to acquire dollars due to the severe credit crunch.

Warnings of a crisis in Europe were also emerging, since many of the financial transactions in the EU were conducted in dollars, not euros.

Given the dire situation, it was only a matter of time before European commercial banks — already struggling to obtain dollars in their own markets — would be forced to cross over the Atlantic and descend on the New York market. European banks swarmed the US market in the early New York hours, before European markets had yet closed.

In the aftermath, the federal funds rate that month skyrocketed above the Fed's target of 5.25%. The federal funds rate refers to an ultrashort-term interest rate charged when a bank lends reserve funds to another bank for one day. It has a major ripple effect on the overall US economy, as it impacts various market interest rates as well as other economic variables.

This is why the Fed had no choice but to take action. Although the Fed immediately expanded the dollar supply, the effect was limited.

At that time, the Federal Reserve Bank of New York bought US$24 billion in government bonds to release dollars in the market. The liquidity supply continued after that, but the credit crunch did not improve significantly. Something extra was needed.

One of the alternatives the Fed conjured up was to arrange a currency swap with the European Central Bank (ECB).

The idea was to take euros from the ECB and use them as collateral to lend dollars. It was believed that doing so would allow the ECB to release more dollars into the market without having to use its foreign reserves, thus eliminating the need for European commercial banks to flock to the United States for dollars. In this case, even if the banks failed to pay back the money, the risk would fall on the ECB, not the Fed.

Bernanke, who was Fed chairperson at the time, explained in his autobiography “The Courage to Act” that the purpose of this move was to protect and isolate the US market from turbulence in the European financial market.

If anything, it was the ECB that hesitated to act. This stemmed from concerns that it might draw too much attention to the crisis in the European market, spreading perceptions that the Fed was the one “bailing out” Europe.

Indeed, Bernanke recalls that the Europeans were reluctant to carry out a swap at first. Eventually, the Fed compromised by deciding to announce the swap together with other emergency liquidity supply measures, as opposed to announcing it separately. In other words, the Fed showed care to draw less attention to how serious the financial instability in Europe was.

US currency swaps expanded rapidly afterwards. In December 2007, the Fed carried out currency swaps worth US$20 billion and US$4 billion with the ECB and the Swiss National Bank, respectively.

The Fed’s currency swaps, which had previously totaled US$24 billion, increased to US$620 billion following the Lehman Brothers crisis in 2008. The number of central banks that engaged in currency swaps with the Fed also increased to 14.

In October 2008, there was no limit on the amount of currency that Europe, Switzerland, the United Kingdom, and Japan could swap. At that time, the amount withdrawn by the ECB alone amounted to US$313.8 billion.

Just as the currency swaps were first proposed out of US necessity, the same calculations were applied in selecting additional countries to take part in swaps.

“We expanded our currency swap lines yet again at the meeting by adding four carefully chosen emerging economies: Mexico, Brazil, South Korea, and Singapore,” Bernanke writes. “We chose these countries based on their importance to US and global financial and economic stability, declining requests for swaps from several others [considered less important].”

Currency swaps reemerged as a way to rescue the financial market when the COVID-19 pandemic left it in precarious condition in 2020.

As the short-term financial market froze up at the time, it became difficult for the foreign commercial banks that depended on it to obtain dollars. The resulting financial instability that spread around the world — including in the US — brought the need for currency swaps to the fore once again

By then, the Fed had already created a permanent network of currency swaps that allowed for unlimited exchanges with five central banks in Europe, Switzerland, the UK, Japan, and Canada. As the situation continued to worsen, the Fed signed additional currency swap deals with the central banks of nine other countries, including South Korea. The Bank of Korea, which reached a deal to swap US$60 billion worth of currency in March 2020, also withdrew up to US$18.8 billion to spend.

The Fed’s attitude this time was similar to its approach during the global financial crisis. It saw that if the conditions of the dollar market were to deteriorate, the crisis would eventually spread to the US.

According to the minutes of a conference of the Federal Open Market Committee held in April 2020, the committee members judged that “[currency swap arrangements with South Korea and eight other countries] should help lessen heightened strains in global US dollar funding markets, thereby mitigating the effects of these strains on the supply of credit to US households and businesses.”

This view explains why the Fed actively pursues currency swaps despite the risk of souring public opinion. During the global financial crisis, the Fed reportedly raised concerns that currency swaps might be seen as bailouts for foreign commercial banks. There were also concerns of possible pressure from politicians.

On this point, Bernanke writes in his autobiography, “To my relief, most of the [. . .] senators [I met with] seemed to appreciate that promoting global financial stability was in the interest of the United States.”

By Lee Jae-yeon, staff reporter

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