Central Banks have set up swap lines mainly with Fed to alleviate dollar liquidity in their home markets. (see this for all swap lines set by different central banks; see this for a nice short primer from Macroblog).
I came across this paper from Maurice Obstfeld, Jay C. Shambaugh and Alan M. Taylor where authors discuss the impact of these swap lines.
In the first part of the paper they discuss a model for predicting currency reserves. They show that in economies that hold reserves higher than their predicted figures, currency has appreciated. In the second part they relate these reserves with swap lines.
Why are such swap lines needed? Two alternatives for the provision of dollar liquidity in the foreign country would be (a) for the foreign central bank to provide the domestic currency and let the bank sell the local currency for dollars on the open market or (b) for the foreign central bank to use its own dollar reserves to provide the liquidity. The former would put downward pressure on the local currency and the latter would possibly exhaust the central bank’s dollar reserves. Examining current reserve holdings relative to our positive model’s predictions is a useful way to provide some empirical context for these swap lines.
And the analysis says:
The swaps were clearly of very large magnitude for many advanced countries. For every advanced country except Japan, the size of the swap was greater than 50% of actual reserves held and in the case of the U.K., Australia, and the ECB, the swap was larger than the existing level of reserves.
In contrast, the swaps to emerging countries are never larger than 50% of their actual reserves. Further, in most cases, the country already had more reserves than predicted. Korea’s was $30 billion, though the country already had $260 billion. For Singapore the figure was , $30 billion against $162 billion already held, and Brazil received $30 billion versus $180 billion on hand. It is hard to see how these magnitudes could be very meaningful; all three countries already held more reserves than predicted by our model. Instead, these swap lines could be interpreted as signals. For Mexico and Hungary, the swaps are more substantial relative to actual reserves and those two countries were holding fewer reserves than predicted, so the swap lines may have had a more substantive impact beyond mere signaling in those cases.
This is really interesting. Swap lines are useful for advanced economies but are just symbolic for emerging economies. They are mainly used as signalling devices in case of emerging economies. This also throws open the case to hold excess reserves:
The swap lines also have implications for reserve holdings. One could argue that the expectation that such swap lines could be available rationalizes advanced countries’ decisions to hold fewer reserves than other countries. This would suggest EM countries will continue to hold large reserves until they are confident that they will have access to substantial foreign exchange swaps when in need.
Alternatively, these extraordinary measures may have been just that— extraordinary. The advanced countries may now recognize this and increase their reserves stocks (or in some cases adopt the euro to reduce the need for reserves). An increase in IMF resources could also be in the cards.
It will be interesting if developed economies start to maintain higher reserves after this crisis. Where would they invest the reserve monies? US Treasuries?