"It is quite possible that, following this time’s swap agreement between five central banks, a monetary arrangement for “dollar defense” will be concluded in the near future ~
** If the swap agreement against the United States is restored, without a doubt, it will work as the most important safety net on which the destiny of the Japanese economy will depend, unlike the former agreement"
Overinterpreting “currency swap agreement”
On April 6, 2009, five central banks of Japan, the United States and Europe concluded a currency swap agreement by which each central bank accommodates the Federal Reserve Board (FRB) with funds in currencies “other than dollar,” such as yen and euro.
Although its direct purpose is to help American financial institutions buy foreign currency, the agreement is also expected to have an indirect effect of supporting the dollar itself. In fact, it has the same principle as that of foreign exchange intervention to defend the dollar.
Although what I am going to discuss hereafter might be a kind of overinterpretation, I would like to consider the mechanism of the “intervention for dollar defense” that might happen eventually, by analyzing the above-mentioned swap agreement.
This swap agreement allows central banks of Japan and Europe to supply the FRB with their own currencies. Specifically, when it is difficult for U.S. banks to buy yen or euro, the BOJ and the European Central Bank (ECB) are to provide funds to the FRB in their currencies, while the FRB receives the funds and in turn furnishes them to the U.S. banks.
The Bank of England (the central bank of the United Kingdom) and the Swiss National Bank also joined this agreement to supply pound and franc denominated funds. The BOJ’s quota is up to \10 trillion, which is almost equivalent to the ECB’s. The whole amount for the currencies reaches as much as about 30 trillion yen if quoted in that currency.
Actually, market players were rather suspicious of this agreement. As the FRB had already supplied a large amount of money, they “had not been much worried about the U.S. banks’ financing, including that for foreign currencies” (an employee of a commercial bank). If there is no problem in the current financing, the agreement might be intended as a preventive action for future contingencies. However, some people point out that “the FRB’s helping the U.S. banks even to buy foreign currencies seems to excessive support.” (Thus commented a fund manager of an asset management company)
Aiming to stabilize the dollar exchange rate？
Although it may sound like an overinterpretation, it is likely that this agreement aims to stabilize the dollar exchange rate. Generally speaking, financial institutions buy foreign currencies in either of the two ways:
“directly” if liquidity of foreign currency in financial markets is sufficient, or “indirectly” if the liquidity happens to be insufficient, by using swap dealing. Whether to use the direct or indirect method, a choice mostly based on a technical point of view, depends on market conditions. However, if another instance of credit insecurity were to arise caused by American financial institutions in the future, a problem might occur.
Once a financial institution is perceived to be weak, it is difficult for the institution to buy foreign currencies directly, since its credit line is reduced. In this case, that financial institution is forced to depend on indirect fund-raising by swap dealing. But, as the limit of this swap dealing is to be reduced as well, it is highly likely that the institution will end up having to buy foreign currencies by “dollar selling, foreign currency buying."
Since the bankruptcy of Lehman Brothers, it is difficult for American banks to buy foreign currencies〔AFPBB News〕
Actually, after the bankruptcy of Lehman Brothers Holdings Inc. last autumn, the U.S. banks fell into situations just like this, and the “dollar selling, foreign currency buying” by them ended up “contributing to the acceleration of dollar depreciation” (according to a large institutional investor). If foreign currencies are supplied directly from the FRB, such a case of dollar selling can be avoided.
Encouraged by the crisis measures introduced by the Obama administration, the financial insecurity in the United States is currently being calmed down. However, it is still difficult to forecast the future.
If the condition of the real economy becomes worse and worse, the managing conditions of American banks might be destabilized again, leaving their financing more and more difficult. Although this time’s swap agreement is intended to reinforce the safety net for liquidity at the time of the above-mentioned financial crisis, it certainly has a side benefit of stabilizing the dollar.
Interestingly enough, the swap agreement for the purpose of dollar defense happens to have the same system as that used to help in foreign currency buying. The reason why countries are to supply their funds to the United States in the former case is as follows:
Since the intervention to prevent the dollar's sharp drop is “dollar buying, foreign currency selling,” a country should hold a large amount of foreign currencies to buy a large amount of dollars.
Unfortunately, compared to Japan’s and China’s, the United States’ foreign currency reserves are significantly low. According to the statistics of the International Monetary Fund (IMF), while Japan has $1 trillion or more, the United States has only $70 billion. This is less than one tenth of Japan’s reserves.
If the United States is obliged to protect its own currency with such low reserves for intervention, countries are required to accommodate America with their own currencies as the intervention resource. At that time, countries should conclude a currency swap agreement, which has just the same contents as this time’s swap agreement between the five central banks.
If this time’s agreement has the same fund accommodation system, it seems that the agreement can be directly applied to dollar defense. However, as its purpose is not the same, a new agreement may be required. The countries where the central banks are not in charge of exchange policies, including Japan, should determine whether or not they need another agreement. Perhaps the BOJ would conclude a swap agreement for intervention between the FRB, following the green light to be given by the Ministry of Finance which is in charge of exchange policies.
For the BOJ, a swap agreement for foreign exchange stabilization is not an exceptional action. As early as February 2002, the national bank of Japan concluded a swap agreement between the People's Bank of China to accommodate each other with yen and RMB, as a part of the Chiang Mai Initiative (CMI) for the stabilization of the currencies within the Asian region. When the People's Bank of China is to perform “yuan buying, yen selling” to stabilize its foreign exchange rate, the BOJ is to supply China with yen as required. In the case of dollar defense, the BOJ will do the same thing between the FRB.
As the result of the U.S. finance’s expansion, the agreement for “dollar defense” may be restored
As a matter of fact, the BOJ once had a swap agreement with the FRB (actually, the Federal Reserve Bank of New York). The agreement was concluded on October 29, 1963, with the limitation up to $5 billion. However, as the Japanese government and the BOJ focused almost entirely on “yen selling, dollar buying” in order to stop the appreciation of the yen accompanying the high economic growth in Japan, it seems that there were few cases for which this agreement was implemented.
The agreement which had virtually lost its meaning was abolished at the end of March 1999, partly due to the request from the United States. At the same time, the agreements between the German Bundesbank and the Swiss National Bank were canceled as well.
Then, ten years later … the condition of the world economy has totally changed. This time, it was the United States that was struck by an unprecedented collapse of its bubble economy.
Thus far, the growth of the American economy has been accompanied by the “Twin Deficits.” Now, to escape from the economic crisis, the Obama administration is obliged to increase public spending at the largest scale in the history of the country and ...
On the other hand, although the dollar exchange rate has been stable recently, concerns about the dollar's precipitous drop are still hanging over the markets, as a financial analyst from a foreign-affiliated company says: “The rapid expansion of the fund-raising by the American government’s financial administration is reaching its limitation.”
Holding a huge amount of dollars as its foreign currency reserves, Japan is by no means able to abandon the United States. The collapse of the system based on the dollar as the key currency would be a catastrophic scenario for the world economy.
It is quite possible that, following this time’s swap agreement between five central banks, a monetary arrangement for “dollar defense” will be concluded in the near future. If the swap agreement against the United States is restored, without a doubt, it will work as the most important safety net on which the destiny of the Japanese economy will depend, unlike the former agreement
Related Links ~
CURRENCY SWAPS 2008-2009 LINKS ~
