The Bank of England just published Financial Stability Paper No. 36 – February 2016 “Stitching together the global financial safety net”. The paper illustrates the highly connected state of banks, central banks and other entities, and discussed some of the consequences of such linkages, and the safety nets which exist to protect these structures. The paper highlights risks from vulnerabilities in external balance sheets which leave countries exposed to volatility in cross-border capital flows and increase potential demands on the safety net. A timely discussion, in the light of current market volatility.
Financial globalisation and the expansion in global capital flows bring a number of benefits — more efficient allocation of resources, improved risk sharing and more rapid technology transfer. But they can also increase the risk of financial crisis. Indeed, the current market volatility is partly a reaction to the global risks.
On a net basis, more gross capital inflows than outflows have allowed many countries to run current account deficits. Global current account imbalances (measured as the sum of the absolute values of all current account surpluses and deficits) tripled from around 2.3% of global GDP between 1980 and 1997 to 5.5% of global GDP in 2006–08 and were 3.5% in 2014. But net flows concealed even larger increases in gross flows.
On a gross basis, the boom in global capital flows has provided additional sources of finance for governments, banks, corporates and households. This may have increased the efficiency of capital allocation, with capital increasingly able to flow to where it is most productive. Gross capital flows increased to over 20% of global GDP in 2007 up from around 3% in 1980. Cross-border banking was one of the main drivers of this increase in cross-border flows.
Borrowing in foreign currency often complicates adjustment. International banks’ borrowing in foreign currency (both domestically and cross-border) has doubled since 2002, despite a 20% reduction since the peak in 2008. There are now over US$20 trillion foreign currency denominated bank liabilities (Chart 3). And since 2008, outstanding US dollar denominated credit to non-banks outside of the United States has almost doubled to US$9 trillion.
There is a flip side to the rapid rise in cross-border capital flows and external assets and liabilities — countries are more exposed to the willingness of foreign investors to continue funding their financing needs. Cross-border capital flows can be fickle, with foreign investors withdrawing funding in the event of an economic or financial crisis. Concerns about an increase in foreign currency borrowing in emerging markets through international bond markets — mainly by the corporate sector — have recently been centre stage in debates about global financial stability.
In recent years, to reduce these risks to stability, countries have reformed financial regulation, enhanced frameworks for central bank liquidity provision and developed new elements, and increased the resources, of the global financial safety net (GFSN).
A comprehensive and effective GFSN can help prevent liquidity crises from escalating into solvency crises and local balance of payments crises from turning into systemic sudden stop crises. The traditional GFSN consisted of countries’ own foreign exchange reserves with the IMF acting as a backstop. But since the global financial crisis there have been a number of new arrangements added to the GFSN, in particular the expansion of swap lines between central banks and regional financing arrangements.
Swap lines are contingent arrangements between central banks to enter into foreign exchange transactions. The liquidity-providing central bank provides its domestic currency for a fixed term at the market exchange rate, in exchange for the currency of the recipient central bank. On maturity, the transaction is unwound at the same exchange rate so, provided each party repays, neither party has direct exposure to exchange rate risk. The liquidity-providing central bank bears the credit risk of the borrowing central bank. In the event that the borrower is unable to repay, the lender is exposed to the exchange-rate risk on the currency taken. Swap lines can also involve the liquidity provider lending to the borrowing central bank in a foreign currency. In this case, the liquidity providing central bank lends its FX reserves in return for the borrower’s domestic currency, providing wider access to hard currency FX reserves.
Since the global financial crisis there has been a proliferation of swap lines. By October 2008, in response to the seizing up of global financial markets, the Federal Reserve (Fed) had extended swap lines to fourteen countries. Many of these have subsequently expired and not been replaced. The peak aggregate usage across all borrowers was US$586 billion in December 2008. The Bank of England drew US$95 billion from the Fed, which was on-lent to UK resident financial institutions. Other notable facilities were euro-denominated swaps by Sweden and Denmark to Latvia in December 2008, which they extended while simultaneously having swap arrangements with the ECB. And a Swiss franc denominated swapline between the ECB and SNB which was introduced in October 2008. Since 2007 the number of non-Chiang Mai central bank swap arrangements has increased from 6 to 118 (Charts 10 and 11), and involve 42 central banks. Those with a formal limit total US$1.2 trillion.
The new look GFSN is more fragmented than in the past, with multiple types of liquidity insurance and individual countries and regions having access to different size and types of financial safety nets. These new facilities provide many benefits, such as increasing the resources available to some countries and providing additional sources of economic surveillance. However, many facilities have yet to be drawn upon and variable coverage risks leaving some
countries with inadequate access.This paper consider the features, costs and benefits of each of the components of the GFSN and whether the overall size and distribution across countries and regions is likely to be sufficient for a plausible set of shocks. We find that the components of the GFSN are not fully substitutable: different elements exhibit different levels of versatility, have been shown to be more or less effective depending upon the circumstances, have different cost profiles and have different implications for the functioning of the international monetary and financial system as a whole. We argue that while swap lines and RFAs can play an important role in the global financial safety net they are not a substitute for having a strong, well resourced, IMF at the centre of it.
By running a series of stress scenarios we find that for all but the most severe crisis scenarios, the current resources of the GFSN are likely to be sufficient. However, this finding relies upon the IMF’s overall level of resources (including both permanent and temporary) being maintained at their current level.
Our analysis also highlights that the aggregation of global resources can mask vulnerabilities at the country, and even regional, level. In other words, while the current safety net might be big enough in aggregate, there is a risk that, for large enough shocks, gaps in coverage could be revealed. Steps should be taken to ensure the different components of the safety net function effectively together to reduce the risk of gaps appearing.
Policymakers should consider measures which (i) reduce vulnerabilities in external balance sheets which leave countries exposed to volatility in cross-border capital flows and increase potential demands on the safety net; (ii) secure the availability of appropriate GFSN resources, including the IMF’s resource base; and (iii) make more efficient use of the current GFSN resources by ensuring the elements of the GFSN more effectively complement
one another.
