Monday, November 3, 2008


Over the last few days, the US Federal Reserve has opened USD 120 billion (30 x 4) of new swap lines of credit for another quartet of central banks: Mexico, Brazil, South Korea and Singapore. This brings the number of such lines to 14. Similar credit lines have been issued to the central banks of Australia, New Zealand, Switzerland, Denmark, Sweden, Norway and other members of the G7, of which three -- Germany, France and Italy -- are within the Euro. Ten of the swap lines now amount to USD 255 billion, while those with the European Central Bank, the Bank of England, the Bank of Japan and the Swiss National Bank are technically unlimited. Global credit markets froze up in late September after the failure of investment bank Lehman Brothers, limiting private sources of dollar funding. The US Fed move comes as central banks worldwide continue to fight systemic weakness in credit and capital markets. Such weakness has undermined economic prospects and led many to fear a long and protracted global recession.

Under the swap arrangement the Federal Reserve accepts other nation's currencies and some assets in exchange for the dollar until 30th April 2009 as most of the investors, not wanting to take any risk, have withdrawn their money from most countries. This reinforces the role of the central pillar envisaged at Bretton Woods for the US and its currency. To avoid the foreign currency crisis from spreading to other nations the Fed is making sure that the fundamentally sound and well managed magic circle economies have ready access to the US dollar as the fear of getting its money back from these well established central banks is deemed to be negligible. These deals are meant to confirm that the 14 magic circle nations are in relatively good shape compared with emerging nations that are struggling with a shortage of dollar liquidity and the global credit crunch. By virtue of these US Fed swap lines within the magic circle, the US government has in theory virtually guaranteed that these countries will not have to face the prospect of sovereign default anytime soon. Three examples follow -- two in the magic circle -- and one outside:

1. Within the magic circle, South Korea is in dire need of dollars and will use the USD 30bn credit line as its banks and companies are finding it difficult to secure enough dollars to service their debts and pay for business activities. Increased dollar demand has put downward pressure on the local currency, with the Korean Won losing around 34 per cent so far this year. South Korea has said its foreign-currency reserves of nearly USD 240 billion, ranking sixth in the world, were sufficient to avert a repeat of the 1997-1998 financial crisis. However, there are lingering doubts about the ability of the country's banks to service their maturing short-term debt.

2. Within the magic circle, Brazil is a key BRIC and the largest economy in Latin America. It has been troubled by the crisis on its stock market and currency forcing the central bank to inject USD 7.7 billion into the domestic money market to counter the credit squeeze, and is standing by with nearly another USD 3 billion if necessary. Last week it also intervened three times to sell an unspecified amount of dollars from its reserve pile of USD 207 billion to reverse the slide of its currency, the Brazilian Real which has fallen by 30 per cent this year.

3. Absent from the magic circle is Argentina, which is now facing its worst crisis since the 2001-2002 devaluation that saw the country stop paying USD 100 billion in foreign debt -- the largest sovereign debt default in history. On Friday, Standard & Poor's cut the country's low credit ratings even further amid turmoil in the capital markets after the country moved to take over the country's private pension funds. The foreign currency debt was lowered to B-, ie, junk territory. The Argentine Peso has dropped off to six year lows, and credit-default swaps, which measure the cost of insurance against default, have widened to an exorbitant spread. Argentine bonds are trading at levels not seen since 2002. The lack of an extension of a similar swap line from the US Fed -- which would allow the central bank to exchange its currency for dollars in order to help companies pay back dollar borrowings amid a shortage of dollars -- is telling. Given that there has been a sharp depreciation in the currency the general sense is that they are pursuing policies that do not seem to be sustainable in the medium- or long-term.

For the moment, the Federal Reserve's massive expansion of US dollar swaps with other central banks seems to be working to ease liquidity pressures in global markets. This sea of dollars seems to be meeting safe-haven demand for the currency across the world, helping pull down the three-month London InterBank Operational Rate(LIBOR) for US dollars to 3.19 percent on Thursday, from a damagingly high 4.82 percent earlier this month. These spreads remain at levels that are well above normal and other measures of stress, such as the Volatility index, have risen even further. However, some experts say it will be difficult for the magic circle governments to prevent an outflow of dollars if the global credit crisis persists and foreign investors continue to question the prospects for their domestic economies. For the moment, the risk of default on foreign debts has been eased significantly, but the important issue is to erase doubts about their economic fundamentals, including the soundness of the banking sector. One of the key questions emerging at present in this regard is as follows: can the magic circle countries' public finances shoulder these new responsibilities? Will those countries, for example like Belgium (285%) and Switzerland (260%) with short term banking liabilities significantly exceeding GDP (Proportional percentage) be able to bail themselves out? Iceland (211%) could not. It is important that these economies be set up for a soft-landing by gradually removing bubbles in the financial sector and their other economic engines, rather than inviting a bigger risk by maintaining or inflating them with stimulus packages. The Fed has also said it welcomes the International Monetary Fund's decision to establish a short-term liquidity facility for emerging-market countries, adding it supports the IMF's role in helping countries address and resolve their ongoing economic and financial difficulties.

DK Matai
Chairman, ATCA Open

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