Lending Capacity

If an ILLR does not have sufficient resources to put out a financial conflagration, markets will view any proposed response as inadequate and the crisis will continue unabated. Partial insurance is the same as no insurance.

Figure 2.4

ESF Total Assets, 1976-2009

This is why central banks—with their capacity to create liquidity—are the ideal locus of the lender of last resort role within the national context. Like the IMF, the ESF’s resources are finite. Figure 2.4 displays the total assets of the ESF from 1976 until 2009 based on year-end totals.[1] To date, the largest foreign credit provided by the ESF was the $20 billion rescue package for Mexico in 1995. Yet, as I will discuss in chapter 6, even this action required assistance from the Federal Reserve. Because it cannot create liquidity, the ESF has limited capacity to fight global financial crises. Indeed, although the ESF’s ability to respond swiftly to crises gives it a leg up on the IMF, its lending capacity has always been considerably more limited than even the Fund’s. Thus, the typical ESF rescue has capitalized on its comparative advantage as a speedy crisis responder. Much of its foreign lending has been designed to address the problem of IMF unresponsiveness.

Some ESF credits have been used to address IMF resource insufficiency. However, the Treasury has typically pledged such credits alongside an IMF loan with the intent of augmenting the overall financing package. Conversely, the Federal Reserve’s lending capacity is virtually unlimited due to its ability to create money. Of course, not just any kind of money can address international financial crises. In the domestic context, institutions in need of emergency financing require that credit be denominated in their respective national currency. However, in the context of international financial crises, institutions and governments in need of assistance generally need liquidity in foreign currencies. Discussing the need for an ILLR in a globally integrated financial system, Charles Goodhart explains,

Just as commercial banks will turn to their [central bank] when they cannot borrow . . . on acceptable terms in money markets . . . national governments and [central banks] will want to turn to an international LLR when they, or their private sector, cannot borrow foreign currency on acceptable terms in the international money market.[2]

Of course, Goodhart is not just talking about any foreign currency here. In the international financial system, not all currencies are created equal. Most national currencies are used sparingly, if at all, in international financial markets. Only a small number of currencies can be considered truly global currencies that are not bound by geography. At the top of the currency hierarchy lies the US dollar.[3] The dollar is widely used outside of the United States. It lies at the heart of the global financial system.[4] It is the most used currency in international trade settlement and in foreign exchange transactions. It is the dominant global reserve currency and competes with the euro for the world’s most widely used investment currency in banking and securities markets.[5] Understanding the dollar’s dominance in the international currency hierarchy is central to the discussion of the ILLR function in the global economy. Because there is no global central bank that prints one world currency, the degree to which a currency is "internationalized” has serious bearing on the extent to which it could actually be useful to a foreign country or financial institution facing a credit crunch.

Take, for example, a government facing a balance of payments (or currency) crisis. In such an event, sovereigns face market pressure on their official fixed exchange rate from capital outflows and speculation.[6] In order to defend the exchange rate, the government must intervene in international currency markets by buying its own currency and selling foreign exchange. For the purpose of intervention, the country will want to use a foreign currency that will most swiftly generalize the impact on its currency’s exchange rate. This is a matter of economies of scale—or what economists refer to as "network externalities”—and suggests a preference for the dominant currency, the dollar, in official foreign exchange intervention.[7] However, if the government spends down all of the dollars in its reserves, it may need the assistance of an ILLR to provide liquidity in dollars so that it can continue to support its currency and avoid devaluation.

Alternatively, consider the needs of a government on the verge of a default on its external debts. In this case, a country experiences excessive growth in terms of public budget deficits, rendering the government incapable of servicing its current international liabilities. Acquiring new loans from private debt markets also becomes more difficult. In many cases, governments may be forced to seek external financing from an ILLR in order to avoid a disorderly default. The need for external financing is related to the fact that most governments (and many private companies) borrow in foreign currencies—a problem referred to as "original sin.”[8] Thus, a government cannot simply print more of its own currency to pay off its debts because what it needs is foreign exchange. It needs assistance denominated in one of a few select currencies that dominate global debt markets. Prior to the introduction of the euro in 1999, the dollar was the dominant currency in international debt markets. The euro has emerged since its introduction as the second key currency in debt markets, though the dollar has recently been expanding its role again.[9] In sum, an effective ILLR must be capable of providing liquidity in the proper currency. In most cases, the proper currency is the dollar.[10]

When it comes to lending capacity in dollars, no entity can compete with the Federal Reserve. Because of its ability to create liquidity denominated in the tender that most closely approximates global money, its capacity to fight international financial crises is virtually unlimited. Consequently, unlike the ESF, the Fed is ideally positioned to address the problem of IMF resource insufficiency, especially during "five alarm” global financial crises like what occurred in 2008.

  • [1] Data were collected by a research assistant from relevant US Treasury bulletins. ESFassets have historically been denominated in a select few hard currencies, including theUS dollar, the German deutschemark (later the euro), the Japanese yen, and also SpecialDrawing Rights (SDRs).
  • [2] Goodhart 1999, p. 349. Emphasis added.
  • [3] Cohen 1998.
  • [4] For more on the concept of international currencies, see Cohen 1971, 1998, 2006.
  • [5] Cohen and Benney 2014; Goldberg and Tille 2008.
  • [6] The literature modeling currency crises is typically divided into three generations. Fora first-generation model, see Krugman 1979; for the second generation, see Obstfeld 1986;for the third generation, see Dooley 2000 and Kaminsky and Reinhart 1999.
  • [7] Countries are also more likely to rely on the currency that is most commonly used tosettle their foreign trade transactions. Therefore, one would expect that peripheral Europeancountries—which trade predominantly with the European Union—would lean towardusing the euro; Latin American economies and oil exporters, on the contrary, would favorthe dollar. On a global scale, we know that, based on the available data, about half of globalexports are invoiced and settled in US dollars. This is followed by the euro, which accountsfor 15 to 20 percent of exports (though this is concentrated around Europe). The remaining30 percent or so is composed of a mix of monies, though in comparison they are marginalcompared to the dollar and euro (Cohen 2013; Goldberg and Tille 2008). From this angle,then, the dollar and the euro are the most obvious choices for intervention purposes.
  • [8] Eichengreen and Hausmann 1999, 2005.
  • [9] Hiroyuki and Rodriguez 2015.
  • [10] Others have made similar points. Keleher (1999, 4) once noted that the world’s topcurrency is "for all practical purposes analogous to monopoly issuance” at the global level.He added, "In global financial crises (liquidity shortage) situations, managers of dominantinternational currencies should accept responsibility to supply needed world liquidity: toact as international LLR.” Similarly, Kindleberger once implicitly acknowledged that theILLR responsibility falls to managers of dominant reserve currencies (1983, 84-87).
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