Foreign exchange reserves are traditionally held for use in times of national economic emergencies and few now doubt that is exactly what faces countries around the globe needing to shore up and recapitalize chunks of their banking systems.
Drawing on massive dollar swap lines from the U.S. Federal Reserve — lines recently doubled to central banks worldwide to more than $600 billion — is one thing. Swaps are temporary and get unwound back to the Fed again.
But open-ended use of dollar reserves is quite another.
And one sizeable implication in using dollar reserves to ease the crisis is the impact it may have on U.S. Treasury securities — where overseas central banks now park $1.7 trillion of their dollar windfalls — at precisely the time when the United States needs to raise tens of billions of dollars of new debt.
"At some stage all measures have to be considered — imaginative use of FX reserves in just one example of the sort of ‘out of the box’ thinking that is now necessary," said Jim O’Neill, chief global economist at Goldman Sachs.
On Tuesday, for example, the third biggest reserve holder Russia announced an extra $36 billion of long-term help for its banks — over half of which will come from its central bank. Russia’s gold and foreign exchange reserves have already dropped by some $25.6 billion last month alone to $556 billion in defense of the battered rouble.
South Korea, which has spent $25 billion of its foreign currency reserves in defense of its won exchange rate since March, also said this week it would give its ailing banks access to its $240 billion reserves — the world’s sixth largest.
South Korea’s President Lee Myung-bak said on Wednesday that China, Japan and South Korea, having combined foreign exchange reserves in excess of $3 trillion, would not face a financial crisis similar to the one unfolding in Europe.
The debate in China about just how to use the firepower of its $1.8 trillion of reserves is raging.
And some analysts say the euro zone’s banking crisis is at such a pitch that it may even be worth considering how the euro zone system of central banks — which collectively holds $285 billion of FX reserves — might best use its dollars too.
"One possible route out of this spiraling dollar shortage is for European governments to use foreign currency reserves to provide dollar capital directly to the banks," said Joe Prendergast, Investment Adviser at Credit Suisse in Zurich.
Prendergast said restrictions related to European monetary union rules may restrict use of euro zone dollar reserves but a possible solution would be to tap the reserve to offer banks direct dollar loans that could be repayable in euros.
WHY SO SHORT?
A dollar shortage around the world has become the crux of the 15-month-old financial crunch because the near collapse of many U.S. mortgage-related assets has sent banks in Europe and elsewhere scrambling to find dollars to repair balance sheets.
The International Monetary Fund on Tuesday increased its estimate of declared losses on U.S. dollar loans and securitized assets in this financial meltdown to $1.4 trillion, up almost half a trillion dollars from its estimate in April.
And it estimated that major global banks will need about $675 billion in additional capital over the next few years.
"Without the ability to obtain new capital from private markets, recapitalization using the public sector balance sheet should now be considered," the IMF said.
But how did the dollar shortage snowball?
A simple example is that when a European bank takes a 50 percent writedown on a $2 billion asset, it still has to roll over $2 billion of short-term dollar financing all the way to maturity, even though the asset is then only worth $1 billion.
The writedowns themselves fuel counterparty distrust on interbank lending markets and make rollover beyond overnight loans extremely difficult.
"European banks with large holdings of dollar assets were especially exposed," the IMF said on Tuesday, adding that they responded by raising more funds in euros, Japanese yen and British pounds and swapping them into dollars using foreign exchange and cross-currency swaps.
The strain this put on swaps markets led to the global central bank swap lines. Yet this didn’t fully ease the problem.
A big problem, as Credit Suisse’s Prendergast pointed out, is the writedowns created a currency mismatch on banks’ books.
In the simplified example of a 50 percent writedown of a $2 billion asset, the notional European bank will end up with a $1 billion dollar net short position — one its auditors will require it to cover by buying dollars to avoid the exposure.
As the dollar has surged about 15 percent against the euro since troughing in July, the euro size of the exposure has grown — and the need to buy dollars to close that gap has merely accelerated its rally.
Hopes that all those pressures might abate as banks’ third-quarter accounting ended last month have been already been replaced with gloom about fourth quarter refinancing needs — further underlining dollar demand.
Credit Suisse said it expects European banks to face significant net redemptions of dollar debt through the final quarter — with maturities of their U.S. dollar bonds particularly high in October. This must be met with dollar cash.
"Central bank intervention to sell dollars cannot be ruled out, in the event that the rush to hedge net dollar liabilities creates an increasingly disorderly FX market," said Prendergast.