Temporary reciprocal currency arrangements between central banks, called swap lines, may be better than stockpiled foreign reserves when it comes to providing dollars to domestic banks during times of market stress, according to new research published in the latest Quarterly Review by the Bank for International Settlements.
Researchers found the Bank of Korea's (BoK) use of part of a $30-billion swap line facility with the US Federal Reserve during the global financial crisis from 2007 to 2008 was more effective than using its own foreign reserves when it came to injecting dollar liquidity into the banking system. "The experience of Korea can provide useful lessons on the effectiveness of the two different policies in mitigating foreign currency funding problems," said Ilhyock Shim, an economist at the BIS, and Naohiko Baba, a senior economist at the Bank of Japan, in their report, Policy responses to dislocations in the FX swap market: the experience of Korea.
The pair noted that a major reason leading to their conclusion was that Bank of Korea's loan auctions funded by the Fed swap line effectively added to Korea's foreign reserves, whereas by contrast, providing dollar liquidity from the official reserves would have reduced the reserve coverage.
Shim and Baba said since Korea's loan auction from the swap line did not result in reduction in the country's foreign reserve deposits, it was likely to have enhanced market confidence. "BoK loans funded by the swap line with the Fed were more effective than using its own foreign reserves," they said.
"Even though building up a large amount of foreign reserves has certain merits as self-insurance, once a country faces a foreign liquidity run, swap lines with other central banks can have a powerful effect of complementing the use of foreign reserve and thus stopping the run,'' Shim and Baba said.
To alleviate a shortage of dollar liquidity during the global financial crisis, the Bank of Korea drew heavily on its foreign exchange reserves. But it also established a dollar swap line with the Federal Reserve in October 2008 to provide short-term dollar funding. The suite of policies helped stabilise Korean financial markets and promote recovery of the economy. Shim and Baba noted that when the auctions were conducted, Korea's foreign reserves were just enough to cover the country's short-term foreign currency debt.
In late May, chairman of the Federal Reserve System, Ben Bernanke, lauded the Korean central bank's response to the crisis during a speech in Seoul. He said the two important features that helped ease acute financial stress were the increased use of unconventional policies and enhanced co-operation among central banks, including between the Bank of Korea and the Federal Reserve.
‘'But even as central banks develop new tools to address new challenges, they must continue to place great weight on the factors that have been shown to enhance the credibility and effectiveness of monetary policy-central bank's independence, accountability and transparency, and effective communication.'' Bernanke said.