US Dollar shortage and global policy response

BIS Working Paper No 291 titled 'The US dollar shortage in global banking and the international policy response' by Patrick McGuire and Goetz von Peter deals with the international policy response to the stresses in the banks balance sheets last year. 

An important point noted by the paper:

Beyond addressing the immediate exigencies, however, the international swap arrangements are of broader interest from an institutional perspective. The structure of the arrangements appears to overcome two challenges commonly associated with international lending of last resort. First, the Federal Reserve and its foreign counterparts have the power, in principle, to create any amount of money, in contrast with international financial institutions administering limited resources. Demands in other currencies can similarly be met by including the respective currency-issuing central banks in the network of swap lines. Second, the swap network does not compound the informational problems that can give rise to moral hazard. By lending against collateral to foreign central banks that intermediate those funds to banks in their jurisdictions, the Federal Reserve assumes no credit risk vis-à-vis the ultimate borrowers, and delegates the task of monitoring the banks (or collateralising the loans) to the national authorities closer to the bank supervision process.

Conclusion of the paper:

The recent financial crisis has highlighted just how little is known about the structure of banks’ international balance sheets and their interconnectedness. The globalisation of banking over the past decade and the increasing complexity of banks’ international positions have made it harder to construct measures of funding vulnerabilities that take into account currency and maturity mismatches. This paper partially fills this void, investigating how banks funded their international positions across currencies and counterparties. The analysis shows that between 2000 and mid-2007, the major European banking systems built up long US dollar positions vis-à-vis non-banks and funded them by interbank borrowing, borrowing from central banks and FX swaps. We argue that this greater transformation across counterparties in fact reflected greater maturity transformation across these banks’ balance sheets, exposing them to considerable funding risk. When heightened credit risk compromised sources of short-term funding during the crisis, the chronic US dollar funding needs became acute, particularly in the wake of the Lehman Brothers bankruptcy.


In contrast to many previous international financial crises, it was banks’ international exposures to other industrialised countries that deteriorated, and the global interbank and FX swap funding structure which seized up. The build-up of such stresses at the global level can only be identified by tracking the extent of cross-currency funding, and by implication, banks’ reliance on short-term interbank and FX swap positions. What pushed the system to the brink was not cross-currency funding per se, but rather too many large banks employing funding strategies in the same direction, the funding equivalent of a “crowded trade”. Only
when examined at the aggregate level can such vulnerabilities be identified. By quantifying the US dollar overhang on non-US banks’ global balance sheets, this paper contributes to a better understanding of why the extraordinary international policy response was necessary, and why it took the form of a global network of central bank swap lines. A broader message of this paper is that vulnerabilities in the international financial system are best measured along the contours of banks’ consolidated balance sheets, rather than along national borders. ....
The macroprudential perspective afforded by these data shows that (i) stresses can build up in a national banking system that cannot be identified with the home country’s residencybased statistics alone, and (ii) banks’ cross-border positions are large relative to countries’ external positions, clouding the interpretation of what the “national balance sheet” implies for domestic residents.

Food Security and Poverty

My article on the proposed Food Security Act in India is in the Financial Express today. The Government's proposal in principle extends the right to food to all citizens in India but limits the legal binding on it only for the population that lies below the poverty line (BPL) - and here there is a wide range of the estimates of poverty in the country - ranging from 38% according to the Tendulkar committee set up by the Planning Commission recently to 77% set by the 2007 Arjun Sengupta Committee. The NC Saxena Expert Group for the 2009 Census of BPL households in rural areas puts the estimate at 50%, but says that 80% of rural households would be more appropriate if the calorie consumption is to be 2,400 calories in rural areas

Read the Report of the committee on the methodology for estimating the population in India below the poverty line, particularly the dissent note by P. Sainath for a compelling argument on why coverage of the food security act should be universal.

My conclusion in the article:

The reason behind limiting coverage of the Act has to be fiscal, and the Centre should admit that outright. Under the present Public Distribution System (PDS), the higher estimates of BPL population can raise the food subsidy bill by 25% to 140%, depending on which estimate is used. However these estimates assume that the PDS continues in its present form. Instead of looking at the high subsidy costs as a deterrent, the Centre should keep the spirit behind a Food Security Act foremost in mind—systems set up should be decentralised and allow greater flexibility to the states with the idea for organisational cost savings. A simple example is to distribute coarse cereals, pulses, fruits and vegetables suited to the local conditions through a revamped, new PDS, rather than use rice or wheat transported long distances from other states.


In fact, if the primary responsibility of providing food security is to lie with the state governments, as the Act proposes, why not minimise the role of the Centre to being a facilitator, rather than a controller of the whole food stock trade and distribution? There is much to be said for making the right to food a universal right and there is ample evidence to show that targeted systems increase the scope of corruption. Clearly, the Food Security Act is an important step forward, but it should not narrow its focus and result in two steps back in the battle against hunger in this country.

Elinor Ostrom and Economics

Good to see the 'Nobel' Prize going to a 'non-economist'..Elinor Ostrom is a political scientist.
Read a list of her work here

Here is her CV 
For those who want to debate whether she 'deserved' the Prize at all, like the big discussion that raged over the weekend on Obama, you can put in your comments at this site.. Some comments are pretty low level here, showing that a lot more effort will be needed to get economics to accept a multi-disciplinary approach. So whether she 'deserved' the prize or not, whether there are others who 'deserve' it more or not, discussion is endless..still, this is a step in the right direction on bringing plurality back into focus. A refreshing change from the market vs. government arguments, she stresses on cooperation e.g farmer managed irrigation systems etc..


In an interview, 
The first woman to win a Nobel economics prize, announced today, emphasizes in her work, for example, how pools of users manage natural resources as common property, such as how lobster fishermen in Maine in the 1920s came together to self-police the industry due to too many of the sea creatures being captured threatened their extinction

"They regrouped and thought hard of what to do, and over time developed a series of ingenius rules and ways of montoring that have meant the lobster fishery in Maine is the most successful in the world," she said today, in a wide-ranging interview with Adam Smith, editor-in-chief of the Noble prize group's Web site, Nobelprize.org. "There are many other small- to medium-size groups that have taken on the responsibility for organizing the source governance."
She agreed her award might catch on with the public in more broad ways, arguing that government oversight isn't the only way to solve a problem.
"I hope," she said. "That's what I've been working on for all my life. Humans have great capabilities, and somehow we had sense that the 'officials' have genetic capabilities that the rest of us didn't have. I hope we can change that."

You can hear the whole interview here


UPDATE: Here is Paul Romer on Ostrom's significance:


Cheers to the Nobel committee for recognizing work on one of the deepest issues in economics. Bravo to the political scientist who showed that she was a better economist than the economic imperialists who can’t tell the difference between assuming and understanding.


Here is Ostrom on climate change (Thanks Suvrat, for this link)


The first part of the discussion moves from a review of systems thinking to focus on social-ecological systems and their resilience, to the challenge of managing these systems so they can be resilient: How will they best cope with change? In the second part of the conversation, Ostrom elaborates on the framework she’s been developing, which she describes as “a step toward building a strong interdisciplinary science of complex, multilevel systems that will enable future diagnosticians to match governance arrangements to specific problems embedded in a social–ecological context.” In wide-ranging observations, she also discusses how people self-organize successfully; the role of trust and reciprocity; and the preservation of ecological knowledge.

Rate hikes again

The RBA is the first off the block raising rates this week. In a speech at the Istanbul conference on 'Where is Global Finance heading?', Mr Durmuş Yilmaz, Governor of the Central Bank of the Republic of Turkey made some key points about the role of central banks. It is important that the public and analysts appreciate what is behind the actions of central banks. And also to remember that each country faces a different set of conditions and priorities, timing and pace of rate decisions will necessarily differ.

Almost all economists agree that we are heading to a slow, gradual and painful recovery. And as a central banker who has spent almost 30 years in this profession, I can tell you that it is a miracle itself to have so many economists agree on one issue with so much vigor and conviction.
It is clearly understood that the only way to prevent future crises at the global scale is multilateral cooperation. However to establish and sustain multilateral cooperation is not an easy task. As (John Maynard) Keynes once said, “The biggest problem is not to let people accept new ideas, but to let them forget the old ones.“ It is very likely that economic agents will try to hold onto their old habits when the effects of the crisis subdue.
Appeals on regulators will pile up for a more lenient implementation of rules, regulations, and policies. Politicians will face pressure from their constituents to give priority to local concerns at the expense of global coordination. Dominant academic paradigm may restrict those who radically incorporate lessons of these days into their studies. And of course, central banks, as always, will be criticized for spoiling the party at its hottest moment by taking away the punch bowl. We should be aware that keeping the old habits will only give us a new and may be more severe crisis in the near future.

Of course, as a central banker, I am fully aware that identifying asset bubbles is not an easy task and it may also be challenging to convince the public and politicians about the necessity of raising policy rates at a time when economy is booming but the prices of goods and services are stable. However, the recent crisis has demonstrated that central banks may ignore imbalances in financial markets at their own peril.

Financial crisis and central banking

Marc Faber in an interview recently praised the RBI for being amongst the best central banks in the world - mainly from the point of view of keeping an eye on financial stability:
The RBI has one of the best monetary policies in the world because they supervise the financial sector very closely. They have maintained relatively tight monetary policies and also they pay attention not only to core inflation which is not representative of the cost of living increases and is not representative of inflation in the system but the RBI also pays attention to rising and falling asset prices. So, I have to give them credit for being actually one of the best Central Banks in the world.


That's the view from the investment world, yet the RBI has often been criticised by economists for being ultra-conservative. Shankar Acharya talks of the good performance of the RBI in his article dealing with policy continuity at the RBI


But the conventional wisdom attributes this to an instinctively conservative and cautious approach of the RBI and its leadership, especially then governor Y V Reddy and deputy governor Rakesh Mohan. At best this is a partial truth and, at worst, it’s quite misleading. Let me explain. Reddy and Mohan should certainly get a lot of credit, but for much more than being instinctively conservative.

To begin with, maintaining a cautious stance in the boom years of 2003/4-2007/8 was itself quite a feat in those exuberant times when the financial community, the media and even the government were pressing for rapid progress on conventional, financial liberalisation. 

But the Reddy-Mohan RBI did much more than just preserve key elements of the policy/regulatory framework. Over the boom years, as the perceived scale and risks of global financial excesses mounted inexorably, the RBI evolved a diverse set of heterodox policy responses to deal with the problem. These included:

• The inclusion of “financial stability” as an explicit objective of monetary policy;
• Active management of surging and volatile capital inflows through partial “sterilisation” by market stabilisation scheme (MSS) security issues, cash reserve ratio (CRR) hikes and liquidity adjustment facility (LAF) operations, thus retaining substantial, discretionary control over monetary and exchange rate policies;
• Moderation of bank exposure to asset bubble-prone sectors such as real estate and equity markets through countercyclical provisioning requirements and differentiated risk weights for bank lending to such “sensitive” sectors;
• Extension of stronger regulation to systemically important non-bank finance companies;
• Enhanced supervision of financial conglomerates;
• Bringing bank exposure to non-banks within the prudential framework;
• Tighter guidelines for securitisation and a sceptical stance towards complex financial products.

After a challenging year of crisis management, Governor Subbarao has explicitly endorsed the key elements of the Reddy-Mohan heterodoxy. It has probably helped that mainstream, international thinking on these issues has been driven much closer to the Reddy-Mohan positions by the global financial crisis. For those, like me, who backed the Reddy-Mohan approaches to monetary and regulatory policies, the continuity shown by Subbarao’s RBI is very heartening. For earlier critics of these approaches there may be some disappointment and discomfort.

So true! For those who are looking for a short roundup of the issues plaguing EMEs today, Subbarao's latest speech on the crisis and EMEs is worth reading. His conclusion:

It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear justified. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill. This judgement skill is the one that central banks, especially in developing countries such as India, need to hone as they simultaneously pursue the objectives of growth and financial stability.