Now that it is apparent that the United States Fed no longer considers important, the impact of its actions on the global economy, let’s ponder on a bit of history.
In 2007, when the global financial crisis was attaining colossal proportions, the Fed had an epiphany regarding its responsibility towards ‘other countries’.
Realising that safe-haven demand for the US dollar will send the greenback’s value soaring, the Fed established the Dollar Liquidity Swap Lines under the authority of ‘Section 14 of the Federal Reserve Act.’
Fourteen so-called primary central banks of the world were identified, and allowed to swap their respective currencies with the USD at a mutually agreed spot rate.
The logic behind this arrangement was that the identified central banks could borrow cheap USD and distribute it within their respective domestic economies through commercial bank networks. Once the contracts expired, the borrowing central banks would return the USD to the Fed at a pre-determined exchange rate.
Strategically or not, apart from the Bank of Japan, South Korea, and Singapore, none of the 14 central banks were from Asia or Africa. While the BRICS moniker gained prominence only a few years later, no attempts were made to provide such facilities to those countries in subsequent iterations, despite their exposure to the USD.
By 2010, short-term USD funding arrangements were limited to five central banks: the European Central Bank (ECB), The Bank of England, Swiss Central Bank, The Bank of Japan, and The Bank of Canada. In 2013, the Fed decided that the Dollar Liquidity Swap Lines arrangement would be converted into a standing arrangement with these five banks.
What made the Fed identify these banks as systemically important is still nebulous; nevertheless, this lack of empathy towards vulnerable emerging markets may accelerate attempts of de-dollarisation of the global economy, and a search for an alternative reserve currency or a rather basket of currencies.
Amid normalisation, the USD’s ascent is bringing about havoc in emerging markets, especially frontier economies. The double impact of COVID-19 and the Russia-Ukraine war has already destroyed such fragile economies, and the Fed’s actions are further exposing them to a variety of external shocks.
“An aggressive rate hike cycle in the US will keep the markets nervous near term, as it increases potential macro and flow volatility, and forces emerging market central banks to follow suit,” Amit Tripathi, CIO (Debt) at Nippon Mutual Fund, told this author.
The situation is made worse by the depletion of foreign reserve holdings among their central banks, which are fighting a lost battle to safeguard respective currencies. Rising interest rate environment in the US leads to investor indifference, leaving these central banks with little to no fire power to retain their reserves. This is because most emerging market foreign reserves are primarily denominated in USD.
As debt servicing deadlines approach and galloping commodity inflation mounts pressure on emerging market central banks, the purchase of USD from the open market becomes paramount. Reversal of quantitative easing, however, renders the USD too expensive for these countries, since their significantly depreciated currencies are no longer potent to make such purchases in both spot and forward markets.
Given this ongoing mayhem, maybe it’s time that Fed Chairman Jerome Powell’s attention is diverted towards the potential of the BRICS swap lines, and its implication on the USD.
In 2014, with the New Development Bank, the BRICS also set into motion the BRICS Contingency Reserve Agreement (BCRA).
With a capital of $100 billion, this arrangement is touted to be a possible alternative to the US Federal Reserve’s Foreign Currency Liquidity Swap Lines, acting as a liquidity manager for BRICS nations. Nevertheless, given its small capital size and the mutual discontent among members, the fund doesn’t yet have enough fire power. Things, however, can change rapidly, as dissatisfaction with the Fed is imminent.
“The terminal Repo rate would be in the range of 6-6.5 percent, with front loading of rate hikes over the next 12-15 months. This is reasonably priced in by the debt markets,” says Tripathi, pointing out the vulnerabilities of even large BRICS economies such as India.
All but a higher capitalisation is needed to make the BCRA an effective swap platform among BRICS nation, reducing their dependence on the USD. With further evolution, the arrangement can not only become the custodian of BRICS currencies but also facilitate inter-central bank swap lines with smaller frontier economies, now significantly dependent on countries such as China.
It is highly probable that continued Fed apathy could lead to multiple parallel systems against the USD, in a word that is frankly a ‘Bretton Woods’ construct. If the Fed wants to safeguard its credibility along with that of the USD as a reserve currency, it must reconsider its strategic hedges in a changing world order. That said, for vulnerable economies in Asia and Africa, there is really nothing to lose by adopting an alternative to the USD, as the Fed is not coming to anyone’s rescue.
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