Silvia Albrizio, Ivan Kataryniuk, Luis Molina Sánchez, Jan Schaefer September 29, 2021
Central banks’ swap and repo lines have been used extensively over the past decade to provide liquidity in the currency markets in times of crisis (e.g. McCauley and Schenk 2020, Aizenman et al. 2021). During the Covid-19 pandemic, central bank coordination played a key role in temporarily preventing the turmoil in financial markets from turning into global financial instability (IMF 2020).
The way liquidity lines work is straightforward. When a liquidity line is active between a source central bank and a recipient central bank, the latter can access the source central bank’s currency in exchange for their local currency at the spot rate and at a fixed interest rate that is below the market rate. When due, the same amount of money will be exchanged between the two counterparties at the same fixed spot rate. In this ‘do itWith the agreement, the recipient central bank can, on the one hand, feed liquidity into the domestic market in order to prevent market pressure on its own currency in times of financial stress or to avoid depletion of its own reserves. On the other hand, by reducing foreign liquidity bottlenecks, the source central bank prevents negative spillovers in the form of financial instability (McCauley and Schenk 2020, ECB 2021).
In this regard, previous posts have focused extensively on the Fed’s liquidity lines and its role as an international lender of last resort, but what do we know about those of the ECB? What is the scope and effectiveness of these lines? In this column we present descriptive and empirical evidence (based on Albrizio et al. 2021) on the ECB’s arrangements to provide euro liquidity.
Since the terrorist attack of September 11, 2001, the ECB has participated in the network of G10 central banks, which contribute to the global provision of dollar liquidity.1 In addition, between October 2008 and August 2020 it set up or extended a total of 28 swap and repo lines with 16 foreign counterparties to provide liquidity in euros.
illustration 1 Timeline of the announcements of ECB swap and repo lines providing euro and liquidity in other currencies
source: Albrizio et al. (2021). Database based on ECB press releases, available online here.
note: The figure shows the announcements of ECB liquidity facilities. Above the timeline reports on the establishment of lines between the ECB and other central banks for the provision of foreign currencies (such as US dollars, British pounds, Swiss francs, Chinese yuan). The euro liquidity facilities of the ECB are recorded below the time axis.
Historically, central banks’ liquidity lines have been used for three main purposes: (1) defend a bond system like Bretton Woods (Bordo et al. 2015, McCauley and Schenk 2020); (2) Offering a global liquidity backstop, as is the case with the Fed (Auer and Kraenzlin 2009, Bahaj and Reis 2018); or (3) improving the international use of local currency, particularly in the case of the People’s Bank of China (Bahaj and Reis 2020). As can be clearly seen in Figure 1, the main purpose of the ECB liquidity euro lines has been to provide emergency liquidity as the number of such announcements has increased during times of crisis.
Apart from the agreements within the G10 network, the counterparties to the euro liquidity facilities were mainly non-euro area EU countries (Bulgaria, Croatia, Czech Republic, Denmark, Hungary, Poland, Romania and Sweden). In addition, since March 20, 2020, the ECB has expanded the network to non-EU countries (Serbia, San Marino, Albania and the Republic of North Macedonia). Therefore, unlike the Fed, the ECB was more of a regional lender of last resort than a global one (Figure 2).2
Figure 2 Geographical distribution of the ECB’s euro liquidity facilities: repo and swap lines
source: Albrizio et al. 2021.
note: Countries whose central bank has set up euro swap lines with the ECB are marked in red, while countries with euro repo lines are marked in blue.
Direct effects of ECB liquidity lines: Reduction in foreign currency costs
As pointed out in Auer and Kraenzlin (2009), interbank money markets may not function smoothly during market turmoil. In times of financial stress, it becomes more and more expensive for agents to borrow in the riskier currency markets, making it difficult for banks and corporations to meet foreign currency contracts and liabilities. Previous empirical research has shown that the fed swap lines were effective in lowering the cost of borrowing in dollars (Bahaj and Reis 2018), limiting fire sales of assets, and helping to contain the risk of market contagion. In addition, the mere announcement of the Fed facilities gave market participants confidence without them having to be activated (Panetta and Schnabel 2020), the so-called signaling effect (Aizenman et al. 2021).
We also compare changes in euro refinancing costs in the foreign exchange markets of target currencies with those of currencies of similar non-target countries.3rd To isolate the signaling effect, we estimate these changes in a narrow window around the public disclosure of each liquidity line.4th Figure 3 compares the density of these changes for target currencies and non-target currencies. The distribution for the target countries indicates a shift to the left towards lower euro borrowing costs. In contrast, we do not observe such a shift in the non-target group. This suggests that the ECB liquidity line announcements were indeed effective in lowering euro refinancing costs in the target countries.
Figure 3 Forex base density before and after announcement
source: Albrizio et al. 2021.
note: FX base density in a four day window around the announcement. For each announcement, the treated currency (s) is / are the one to which the announcement is directed, while the non-targeted currencies in the sample are / are untreated. Post-treatment is defined as the day of treatment and the day after (Post), while pre-treatment is the two days before treatment (Pre).
In a more formal assessment, based on a difference-in-differences approach as in Bahaj and Reis (2018), we estimate that the announcement of a swap line will significantly reduce euro refinancing costs in the currency markets, by up to 76 basis points lowers (Figure 4).
Figure 4 Estimated reduction in foreign currency euro financing costs: signal effect
sources: Albrizio et al. (2021).
note: The blue bars represent the estimated effects on the foreign exchange swap base of treated currencies in relation to a group of currencies that are not addressed by line announcements. Sample I includes countries whose currencies were targeted at least once in the period under review (Bulgaria, Denmark, Croatia, Hungary, Poland, Serbia, Sweden). Example II adds currencies of geographically contiguous countries that have never been targeted (Norway, Iceland). Sample III extends sample II to include G10 countries (USA, Switzerland, Canada, Great Britain, Japan) and additional control countries such as New Zealand and Singapore.
Indirect effects: repercussions for banks in the euro area
Liquidity shortages in the foreign exchange markets can trickle back into the domestic market in a number of ways: turning into a global financial instability, increasing financing costs for domestic companies (McCauley and Schenk 2020), or negatively impacting the market valuation of the most stressed domestic banks in markets . Announcements of liquidity lines from central banks can prevent these negative returns from happening by instilling confidence in the economies of recipient countries and reducing the risk of contagion. In addition, Fed lines have generated positive spillbacks as cheaper swap lines increase purchases of dollar-denominated assets from banks in target areas compared to other banks and other denominations (Bahaj and Reis 2018).
To assess the potential repercussions on the euro area, we compare the share price of banks in euro area countries with strong banking relationships with the target countries with those of banks in less exposed euro area countries. We therefore expect that an ECB announcement of a repo line with Romania will benefit more Italian than Belgian banks, as the latter do not have strong banking connections with Romania. Our results suggest that bank share prices in euro area countries that are more dependent on recipient countries are up around 7% at the time of the announcement.
Conclusions: ECB lines are working
Swap and repo lines will become an integral part of the ECB’s stabilization toolkit. As stated in our work, their use makes the ECB a regional lender of last resort, as the ECB increasingly relies on these instruments in times of crisis. The question remains whether these regulations can also stimulate the use of the euro as an international currency, at least at regional level (cf. Panetta and Schnabel 2020). Looking ahead, a wider and more permanent network can strengthen the global safety net and help mitigate the negative effects of capital flow reversals.
Albrizio, S, I Kataryniuk, L Molina and JL Schaefer (2021), “ECB Euro Liquidity Lines”, Banco de Espana Working Paper No. 2125.
Aizenman, J, H Ito and GK Pasricha (2021), “Central Bank Swaps in the Age of Covid-19”, VoxEU.org, April 8th.
Auer, R. and S. Kraenzlin (2009), “Money Market Tensions and International Liquidity Supply During the Crisis”, VoxEU.org, October 14.
Bahaj, S and R Reis (2018), “Central Bank Swap Lines”, VoxEU.org, September 25.
Bahaj, S and R Reis (2020), “Jumpstarting an international Currency”, VoxEU.org, September 21.
Bordo, MD, OF Humpage and AJ Schwartz (2015), “The evolution of the Federal Reserve Swap Lines since 1962”, IMF economic report 63 (2): 353-372.
ECB (2021), “Central Bank Liquidity Lines”, web article of the European Central Bank.
IMF (2020), Financial Stability Report, April 2020.
McCauley, R and CR Schenk (2020), “Swap innovation, then and now,” VoxEU.org, April 12.
Panetta, F. and I. Schnabel (2020), “The Provision of Euro Liquidity through the ECB’s Swap and Repo Transactions”, ECB Blog, August 19.