from Follow the Money

At this rate the world’s financial architecture will have been remade before November 15th

October 29, 2008

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Today the Federal Reserve indicated that it would swap US dollars for Brazilian real, Korean won, Mexican pesos and Singapore dollars -- effectively allowing a select group of emerging economies to borrow dollars on terms similar to those available to the G-10 economies. Or almost similar terms. The G-10 central banks can currently borrow dollars from the Fed without limit; the four selected emerging market central banks can only borrow $30 billion each. But $120 billion is real money -- and if need be, the the size of these swap lines conceivably could be increased.

This move goes some way toward breaking down the line between the G-7 (really G-10) economies and emerging economies that emerged after the G-7 countries guaranteed that systemically important financial institutions in their economies wouldn’t be allowed to fail and the Fed expanded the scale of the swap lines available to European economies whose banks had a large need for dollars. Those moves reduced the risk of lending to another bank in the G-7 (or G-10), but increased the (relative) risk of lending to a bank outside the G-10. German banks needing dollars could get dollars from the ECB, which could get dollars from the Fed. Korean banks had no such luck.

Change has come to the IMF as well. The IMF used to be in the business of providing tranched, conditional loans. And for a long-time the stated goal of fund policy was to return to the funds traditional lending limits (for geeks, 100% of quota in a year, 300% of quota over the life of the program). Now it is willing to lend to some countries unconditionally. And to provide up to 500% of quota upfront. Today’s IMF press release:

The new facility, approved by the IMF’s Executive Board on October 28, comes with no conditions attached once a loan has been approved and offers large upfront financing to help countries restore confidence and combat financial contagion.

"Exceptional times call for an exceptional response," said IMF Managing Director Dominique Strauss-Kahn. "The Fund is responding quickly and flexibly to requests for financing. We are offering some countries substantial resources, with conditions based only on measures absolutely necessary to get past the crisis and to restore a viable external position," he said.

That’s change. There was a time when it was fairly standard to argue that the financing that the Fund provided was almost incidental to the success of a Fund program. The conditions were what really mattered. Now, for at least a subset of countries, the Fund thinks all that really matters is money.

The Fund cannot be a true global lender of last resort so long as it only has $200 billion to lend. Arend Kapteyn of Deutsche Bank noted recently that emerging markets have about $1.3 trillion in short-term external debt (with over $800b owned by emerging market banks) -- a sum that far exceeds the Fund’s resources. But even if its lending is constrained, the Fund can provide financing in way that resemble the financing made available by a traditional lender of last resort.

That is the right move. I agree with Dani Rodrik. The scale of the current crisis demands innovation.

There are also a set of countries that need more than money -- as current account deficits that could easily be financed when leverage was readily available and leveraged players sought out risk are not going to be financed in today’s environment. That requires adjustment, not just financing. Deciding who belongs where will be a challenge. Demand for unconditional financing likely will exceed supply ... in part because some demand will come from countries that need conditional financing.

One other point, or perhaps two -- on the potential geopolitics of today’s moves.

First, all the countries that got access to the Fed’s swap lines are US allies, and all except Singapore are democracies. Russia may be part of the G-8 but it is outside of this club.

Second, it has been fashionable to argue that the crisis would increase China’s financial influence -- as China sits on a ton of foreign exchange and potentially offered an alternative source of foreign currency liquidity. Indeed, China seems keen on doing a deal with Russia that would help Russian state-owned energy firms raise foreign exchange to help cover their maturing external debts -- and the in the process, help reduce the drain on the government of Russia’s foreign exchange reserves.

But so far the crisis hasn’t had that effect -- in part because the US and Europe have moved quickly (by the standards of governments) to help a broad range of countries meet their foreign currency needs. That was driven first and foremost by the needs of the emerging economies -- and the ripple effect their deepening trouble would have on the US and Europe. But I wonder if the possibility that institutions like the IMF could be bypassed if they didn’t respond more quickly and creatively than in the past didn’t help to spur the recent set of policy changes. Those in the IMF’s Executive Board who normally would object to unconditional lending didn’t block the new short-term lending facility -- perhaps at least in part because of recognition that the IMF potentially isn’t the only game in town (or in the world).

China’s rise, in effect, contributed to the a change in the political climate that helped to lift some of the political constraints that in the past limited the IMF’s scope.

I certainly didn’t anticipate this. Three months ago I was among those thinking that the rise of the emerging world’s reserves would reduce the IMF’s future relevance.

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