How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets

One of the reasons why emerging market governments appear to be “creating” alternative means of conducting exchange is because the credit crunch among banks, mainly centered on the US, has restricted their access to US dollars.

Consequently, this predicament has exposed some of the vulnerabilities of Emerging Markets, which can be identified as having too much foreign currency risk exposure, or too geared domestic balance sheets or excessive dependence on short term debts or too large current account deficits.

While the US has extended an almost unlimited swap arrangement with many G-7 countries, outside the G7 the dearth of access to the US dollar has precipitated a cavalcade of crisis among many Emerging Markets such as Pakistan, South Korea, Argentina, Hungary, Ukraine etc…

Our idea is that the recent swap arrangements with G7 nations have been aimed at mitigating the fallout from the ownership of hazardous junk instruments of G7 institutions by having an open access to US dollars by the provision of liquidity through this swap mechanism from the Federal Reserves with the other global central banks.

Aside from, of course, for political reasons, assistance have been extended to US allies.

This only highlights how the present monetary standard operates with the US as its foundation.

Now that the US has been feeling more of the ramifications from the implosion of the domestically originated credit crisis, it has opted to extend its currency swap arrangement to some emerging markets as Mexico, Brazil and Korea. Also to Singapore.

According to the Federal Reserve, ``Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.”

Despite the recent downturn, global trade has significantly supported the US economy, thus the extension of dollar access facility seems to be targeted at cushioning or even inflating emerging market economies for them to sustain economic growth levels enough to continue to buy goods and services from the US.

Aside, there is this hope that once the crisis subside, the EM economies would continue to provide financing to the US by continually buying US financial claims or assets.

But you might wonder how a swap line work?

Mike Hammill of the Atlanta Fed’s research department provides a lucid illustration. His example is based on the September 18^th Fed measures.

From Mr. Hammill (all highlights mine),

``A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.

``Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).

Currency Swap:

``An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.

``However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.

``The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.

``In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.”

Aside from the IMF, the extension of liquidity of the Federal Reserve to other central banks may temporarily allay the problem of liquidity crunch.

And we could be seeing this knee jerk market response via the rally we are presently seeing in Asian equities aside from improvements in the credit spreads as this Bloomberg report,

``The cost of protecting Asia-Pacific bonds from default tumbled after the Federal Reserve increased cross-border funding and the U.S., China and Taiwan cut interest rates to boost economic growth.

``The benchmark index of credit risk for investment-grade borrowers in Asia outside Japan fell the most since it was created in September 2007. The Markit iTraxx Asia credit-default swap index of 50 borrowers, including Thailand and Hong Kong's Hutchison Whampoa Ltd., fell 90 basis points to 470, according to ICAP Plc data as of 9:50 a.m. in Hong Kong.”

Some Thoughts:

-The domino effect of EM economies had been largely exacerbated by a paucity of liquidity amidst global deleveraging and the high risk aversion landscape which amplified the weaknesses of some EM economies to the point of falling into a crisis. If the US extends more of this swap tools to more EM economies then we should likely see fewer financial pressure and perhaps reduce the risks for the IMF to exhaust their limited $200 billion funds. The important difference is that for many EM it has been a liquidity problem, on the other hand, for US banking and financial institutions it has been a solvency issue.

-The global financial crisis is a systemic risk which emanates from the implosion of US credit related financial claims. Any implication that EM economies are in worst condition than its US mortgage collateralized securitization/derivatives/shadow banking peers is unjustified.

-The recent surge of the US dollar can be seen in the light of its privilege as the world’s currency reserve status. In addition, we must not forget that the present crisis which centers on the shadow banking system, derivatives and structured finance are mostly denominated in US dollars, hence, settlement and payment must be made in US dollars. So the US dollar’s rise is unlikely coming from a safehaven standpoint.

-Swap lines are essentially the US Federal Reserve printing presses outsourced to central banks overseas.

-The US has been strenuously exhausting all means to prevent a deep recession which accentuates higher inflation risks down the road.

Spreading the Wealth? Market IS Doing It!

At almost every election period candidates almost always raise the issue of income inequality as one of their top drawing crowd agenda. And almost always the seeming all popular solution has been to find ways to redistribute wealth.

It is like donating part of what you earn (although through legal coercion) to the underprivileged person on the street hoping that he/she uses this to improve on his/her life or at least to his/her family and much more importantly contribute to the wellbeing of society. Noble intentions indeed.

But here is the problem, what if the person turns up to be a dreg who takes your donation only to buy a bottle of gin? What if most of what we redistribute ends up producing a culture of dependency or to the pockets of the so-called wealth distributors? What if societies’ most productive resources are mainly channeled to non productive activities?

The end result is likely a lowered standard of living for the said society.

Nevertheless, who has the widest income equality or tendency to “spread the wealth” among the rich nations?

The answer is the US, that’s according to the Economist, `` And there is a lot of spreading potential: income distribution in America is the widest of the 30 countries of the OECD. The top 10% (or decile) of earners have an average $87,257 of disposable income, while those in the bottom decile have $5,819, among the very lowest of any country. Britain, Canada and Luxembourg also see big differences between the richest and poorest.”

Courtesy of the Economist

So it wouldn’t take so much for US Presidential candidates, during this election season, and liberal media to raise what development author Robert Ringer call as GAVEC ("guiltism", "angerism", "villainism", "envyism", "covetism") to ride along the advocacy to snag political power by promulgating policies of “spreading the wealth”.

But it doesn’t really require politicians to do it.

The way financial markets have been behaving today seems like more than sufficient force for wealth equalization.

For this year an estimated $30 trillion have been wiped off from global equity markets, notwithstanding losses written off by banks (estimated $680 billion) and global real estate markets.

Courtesy of Wall Street Journal

And which social group have been taking THE beating? You guessed... it the wealthiest!

This from Robert Frank in Wall Street Journal,

``The share of income held by the richest 1% of Americans has declined during each of the past three downturns. Between 2000 and 2002, their share fell to 16.9% from 21.5%, according to Internal Revenue Service income data compiled by economists Emmanuel Saez and Thomas Piketty.

``Their share also fell during the 1990 recession, hitting 13.4% in 1992 compared with 15.5% in 1988. The steepest decline was during the Great Depression, when the richest 1% saw their share of income plunge to 15.5% in 1931 from 23.9% in 1928.

"The Depression may be the best analogy for today when it comes to what will happen with income shares," said Mr. Saez, an economics professor at the University of California, Berkeley. He predicts that the share of income held by the top 1% will probably fall to 18% or 19% in the next year or two -- down from an estimated 23% or 24% in 2007.

``During the Depression, the assets of the wealthy declined along with their incomes. In 1928 the richest 1% held 36.5% of the nation's wealth; by 1932 it shrank to 28%. Studies by other economists and researchers show similar declines.

``The main reason for the declines: falling stock values. The wealthiest Americans have a greater share of their wealth concentrated in stocks and financial assets. When stocks plunge, as they have lately, the rich are hit disproportionately.

``The wealthiest 1% of Americans held more than half the nation's direct holdings of publicly traded stocks in 2004, according to the Federal Reserve. Stocks accounted for 11% of their wealth, compared with less than 3% for Americans in the 50th to 90th percentiles. The rich also earn more of their incomes from stock options.

``Of course, the rest of America also is losing wealth and income -- from falling home prices, rising unemployment and declining 401(k) accounts. But rising inequality has largely been fueled by surges at the top, and without capital gains or soaring business profits, those gains will reverse.”

So liberals should now pop the champagne bottles to celebrate the narrowing wealth inequality even without policy actions!

At the end of the day we get ourselves to be reminded of George Orwell's cynical Animalism laws in his satirical novel the Animal Farm ``All animals are equal, but some animals are more equal than others."