Currency swaps are of reciprocal currency agreements (swap facilities) between central banks. The officially purpose of such agreements are explicitly of short term and are intended to finance short-term capital flows believed to be seasonal or temporary in nature. Swap agreements are also misused to facilitate large interventions in foreign exchange markets, which is what is occurring with the dollar today.
How currency swaps work
The easiest way to understand currency swaps is to think of them as two separate zero-interest loans. For example, let's say the fed and the ECB arrange a 80 billion euros ($107 billion) swap. The ECB then lends the 80 billion euros to the US, and the US loans $107 billion dollars to the ECB. Later, at an agreed date, the currency swap is reversed: the ECB returns the $107 billion dollars to the fed, and the fed pays back 80 billion euros.
How central banks use currency swaps
Central banks use the foreign currency from swap agreements to prop up their domestic currency by:
A) Providing the foreign currency to domestic financial institutions. (If those institutions were forced to go to the exchange markets for funding, it would drive down the value of the domestic currency.)
B) Using the foreign currency to directly intervene in exchange markets.
Why currency swaps are so popular
Currency swaps allow central banks to borrow foreign currencies without revealing that their country's banking system or currency is in trouble. In other words, since both central banks involved in a currency swap borrow foreign currencies at the same time, it is difficult to tell which central bank needed them the most. It is this lack of transparency which makes currency swaps so attractive to central banks.
The dangers of currency swap agreements
Currency swaps are temporary measures that need to be unwound. If the central banks involved in currency swaps were responsible in their use of the foreign credit (ie: financing seasonal short-term capital flows), then unwinding the swap agreement is a simple matter. However, if a central bank uses a currency swap to recklessly intervene in exchange markets (ie: desperately prop up a failing currency), then unwinding swap agreement becomes problematic.
Remember that currency swap agreements are essentially two loans. When a central bank misuses a currency swap to prop up its failing currency, it will not have the foreign currency on hand when it comes time to repay the swap drawings. As a result, that central bank will then be forced to issue bonds in foreign currencies to secure the funds to unwind its half of the swap agreement.
The true danger of currency swap agreements is that they allow irresponsible central banks to temporarily prop up their currencies by racking up large amounts of foreign debt. When the swap agreements are later unwound, not only does the domestic currency's value fall, but the nation is left with large amounts of foreign denominated debt.
The US has a history of misusing currency swap agreements
Through the treasury's Exchange Stabilization Fund and the Federal Reserve's System Open Market Account, the United States has twice used swap agreements in failed attempts to prop up the dollar. On both those occasions, the treasury was subsequently forced to issue foreign currency-denominated debt (Roosa bonds and Carter bonds) to repay swap drawings. Evidence of this repeated misuse of currency swaps can be seen on The United States Treasury Department's website.
Treasury policy during 1961-71 period focused on deterring capital outflows from the United States and giving major foreign central banks an incentive to hold dollar reserves rather than demand gold from the U.S. gold stock. The ESF resumed intervention operations in the foreign exchange market in March of 1961 (for the first time since the mid-1930s), but it soon became apparent that the resources of the ESF alone were too small to sustain transactions of the magnitude necessary. At the invitation of the Treasury, the Federal Reserve joined in foreign exchange operations in February 1962. The Federal Reserve entered into a network of swap agreements with other central banks in order to obtain foreign currencies for short-term periods for use in absorbing forward sales of dollars by foreign central banks hedging exchange risk on their dollar holdings. To provide foreign currency to repay the Fed's swap drawings, the Treasury during the 1960s issued non-marketable foreign currency-denominated medium-term securities (Roosa bonds) and sold the proceeds to the Fed.
Later in the 1970s, the US monetary authorities built up foreign currency reserves substantially. For this purpose, the ESF entered in a $1 billion swap agreement with the Bundesbank in January 1978 (which has since been allowed to expire). In connection with the dollar support program announced in November 1978, the Treasury issued foreign currency-denominated securities (Carter bonds) in the Swiss and German capital markets to acquire additional foreign currencies needed for sale in the market through the ESF. The United States also drew its reserve position in the IMF.
Given the US's repeated abuse of currency swaps, it is very disturbing that the fed is once again engaging in an enormous amounts of such agreements. Just last week, Bloomberg reported that the fed has agreed to more swap lines to access euros, yen, and pounds.
Fed Agrees on Swap Lines to Access Euros, Yen, Pounds
By Craig Torres
April 6 (Bloomberg) -- The Federal Reserve and four other central banks announced a currency swap arrangement that will give the U.S. central bank access to as much as $285 billion in euros, yen, British pounds and Swiss francs.
"Should the need arise, euro, yen, sterling and Swiss francs would be provided to the Federal Reserve via these additional swap arrangements with the relevant central banks," the Fed said in a statement today. "Central banks continue to work together and are taking steps as appropriate to foster stability in global financial markets."
The plan, if used, "would enable the provision of foreign currency liquidity" by the Fed to U.S. financial institutions, the U.S. central bank said.
The currency swaps have been authorized through Oct. 30 by the Federal Open Market Committee and are not yet implemented, a sign that central bankers may see no urgent need for the currency lines at the moment. What's more, the Fed hasn't described how it would distribute the currency. One option would be to loan it through the discount window.
"In a regime of greater international cooperation among central banks, it makes sense" for the Fed to have open lines for foreign currency, said Brian Sack, vice president at Macroeconomic Advisers LLC in Washington and a former Fed Board economist.
If drawn upon, the arrangements would let the Fed provide as much as 30 billion pounds ($44 billion), 80 billion euros ($107 billion), 10 trillion yen ($99 billion) and 40 billion Swiss francs ($35 billion), the statement said.
Dollar Swap Lines
Today's announcement mirrors the dollar swap lines the Fed has established with 14 other central banks, ranging from the Reserve Bank of Australia, the Monetary Authority of Singapore, and the Norges Bank, to provide U.S. currency to foreign markets.
Central bank currency swaps don't carry exchange-rate risk because the reversal, which could be as long as three months later, uses the same rates, the Fed says. All told, the Fed's balance sheet reported $308.8 billion in central bank liquidity swaps April 1.
My reaction: The news that the fed has secured more of currency swaps has some very disturbing implications:
1) There would be no need to secure these new agreements if the fed hadn't already used most of its existing $308.8 billion in central bank liquidity swaps.
2) This implies that unwinding the Federal Reserves existing swaps would leave the US with close to 300 billion in foreign denominated debt.
3) This development also implies that much of the dollar's recent rally has been artificially created by the Federal Reserve's 300 billion currency swap intervention.
4) To date, the fed's currency swaps have been presented as motivated by shortfalls in USD funding in foreign institutions. While this might have been true initially, it is now obviously false.
5) Considering that the fed is planning 15-fold increase in us monetary base, 300 billion in foreign debt could quickly turn into 3 trillion or more.
Conclusion: The fed's use of currency swaps to boost the dollar shouldn't surprise anyone. After all, this is the same fed which has let US Banks operate without reserve requirements, caused the housing bubble with low interest rates, and failed to regulate subprime mortgages. Opening credit lines which could help American banks finance a foreign capital flight falls right into place with the fed's other actions undermining the US financial system.
The dollar bubble is reaching its final stages
Soon food prices will begin rising, as the world is headed for a Catastrophic Fall in 2009 Global Food Production. Weather and credit conditions are causing falling production around the globe, and the world's three biggest grain producers are all headed for big shortfalls. In India, torrential rains have devastated wheat crops, while in the US drought and freeze have damaged winter wheat. Meanwhile, Northern China was hit by worst drought in 50 years, and Chinese authorities have ordered three-month, nationwide audit of grain stocks as they are obviously very worried about whether China's grain reserves actually exist.
Inflation in food commodities will push up gold demand cause manipulation efforts to break down. Already, the NYSE has runs out of 1 kg gold bars, and default on COMEX gold contracts is a month or two away. The collapse of paper gold (futures, unallocated gold, GLD, etc...) would destroy what is left of confidence in the US financial system, starting a panic out of the dollar.
Lesson learned from the financial crisis
The truth of this world is that those, who, through stupidity, greed, and fraud, dig themselves into a hole, will keep digging deeper until they hit bedrock and run out of options. This is what happened with Bernard Madoff: he must have known for years his ponzi scheme was doomed to collapse, but he kept it going until he was down to his last 140 million. The United States, like Bernard Madoff, has for years been digging itself into a hole, and the fed's use of currency swaps to boost the dollar is the final part of this process. Unfortunately, the US, like Madoff, is about to hit bedrock.