By Willem Buiter:

On Wednesday, 12th December 2007, five central banks, the Fed, the ECB, the Bank of England, the Bank of Canada and the Swiss National Bank (SNB) are reported to have launched a coordinated attack on the North Atlantic liquidity crisis that has been with us since August 2007.  If they did engage in coordinated action, I missed it.  What I did observe was the simultaneous announcement by these five central banks of "measures designed to address elevated pressures in short-term funding markets".  Except for the timing of the announcements, no substantive coordination was involved. 

The only other bit of coordination included in the announcement was pure eye-candy - window dressing without substantive economic significance.  I am referring to the news that the ECB and the SNB have entered into currency swap arrangements with the Fed of up to $20bn and up to $4bn respectively.  The ECB will conduct repos (sale and repurchase agreements) in US dollars against the usual ECB collateral and the SNB will conduct repos in US dollars against the usual SNB collateral.

Why are these US dollar repos by the ECB and the SNB, and the associated currency swaps meaningless window dressing?  It is because, given the financial opportunities available to central banks and private financial institutions (and given the incentives motivating the latter), the economic impact of the ECB’s (up to) $20bn repo is the same as that of a repo in euro by the ECB for an amount up to the euro equivalent of $20bn, and mutatis mutandis for the economic impact of the SNB’s US dollar repo.  The reason is - and I know this will come as a shock to the central banks involved - that the US dollar, the euro and the Swiss franc are convertible currencies, for both current and capital account transactions, and that the foreign exchange markets for these currencies remain perfectly liquid, thank you very much.

So talk of a US dollar scarcity in the euro area is hilariously silly.  In 1947 there was a US dollar shortage in Europe.  There was limited current account convertibility of the European currencies and effectively no capital account convertibility.  This, however, is 2007.  If commercial banks or other market participants want more US dollars, they can buy them in the foreign exchange market or borrow them.  In the Eurozone, they would need liquid euro assets to buy US dollars, or they would have to borrow US dollars, secured or unsecured.  Indeed they could borrow euros (secured or unsecured) and use these to buy US dollars.  All these courses of action are problematic today because there is a shortage of liquidity in the Euro area, that is, a shortage of euro liquidity, US dollar liquidity, Swiss franc liquidity or indeed any kind of liquidity.  If there were adequate euro liquidity, commercial banks or anyone else could use that euro liquidity to buy eminently convertible US dollars in the extremely liquid foreign exchange market.  The ECB could choose to sterilise its loss of US dollar reserves or not; it could chose to restore its US dollar reserves, or not. End of story.  Dollar shortage - my foot.

Note that this US dollar shortage non-story is very different from the post 9/11 scare when the leading central banks arranged currency swaps on a much larger scale ($100bn between the Fed and the ECB) to prevent any systemic fall-out from the terrorist attack on New York City.  There was a real risk then that the New York Fed, key New York money centre banks and vital clearing and settlement mechanisms could have become seriously operationally impaired.  The physical integrity of the foreign exchange markets was viewed as under threat.  The swap was absolutely the right response then.  But there is no reason for a swap of this nature, or for the ECB doing US dollar repos, when the foreign exchange markets are functioning efficiently.

So why get the central banks involved, and why through swaps? Perhaps it is cheaper, as regards transaction costs, for the ECB to lend US dollars to Eurozone banks through repos, and for the ECB to borrow US dollars from the Fed through a swap, than for the commercial demand in the Eurozone for additional US dollars to be satisfied by private institutions purchasing the additional dollars in the foreign exchange market or borrowing them.  Even if, for whatever reason, the ECB wants to do US dollar repos, it could obtain the US dollars through means other than swaps, for example by purchasing them outright in the foreign exchange market or by borrowing them.  If doing it through swaps is indeed cheaper, and if the ECB can save its counterparties in the US dollar repo transactions a few basis points of transaction costs that way, it would be a nice and neighbourly thing to do.  But it should be doing it all the time, rather than just on special occasions when there is a liquidity crunch. 

So why did the central banks engage in this form of smoke-and-mirrors pseudo-coordination?  One explanation is that they really believed that there was a shortage of US dollars in the Euro Area and in Switzerland, rather than a shortage of liquidity of any kind.  Although even normally reasonably well-informed papers like the Financial Times and the Wall Street Journal have helped spread the ‘dollar shortage’ canard, it is hard to believe that the central banks involved could have been quite so stupid. 

Apart from the simultaneity of the five announcements, there was no further substantive coordination involved.  In addition to the statements by the five pseudo-coordinating central banks, there were links on their websites to statements by two other central banks, the Bank of Japan and the Bank of Sweden.  As regards the Bank of Japan’s statement, it would have been better to omit the link altogether, as it is a prime example of damning with faint praise and even fainter support: "The Bank of Japan welcomes these measures and hopes that they will contribute to maintaining the functioning of the international financial markets. Meanwhile, Japan’s money markets function well and the Bank will continue to conduct money market operations so appropriately as to maintain market stability, including supplying sufficient fund over the year-end."  Translation: "Not our problem.  Good luck."  The Bank of Japan continues to do what it has done so well these past ten years: nothing at all. 

The Swedish Riksbank (which obviously shares its announcement writer with the Bank of Japan) produced a statement of highly positively correlated superficial banality: "The Riksbank welcomes these measures which are aimed at meeting short-term funding needs in international financial markets. In Sweden we do not currently see that the banks have any additional need to borrow money in the short term. We are monitoring developments closely and are, as always, ready to take the necessary measures if the need should arise".

There was no coordination of actions worth mentioning.  This was not like the coordinated foreign exchange market interventions of yesteryear, which did require true coordination as a necessary condition for their effectiveness.  The fact that the ECB and the SNB will do repos in US dollars rather than in euros or Swiss francs and that the ECB and the SNB have arranged small swaps with the Fed, is worth a yawn at best.  It looks like the substitution of motion for action.  It does nothing for the markets’ confidence in the ability of the five central banks involved in the joint announcement to address their bit of the North Atlantic liquidity crisis when these central banks elect to engage in meaningless empty gestures.   

December 13th, 2007 in Central banks | Permalink