Policy Session 3: The US Dollar in the International Financial System
This session covered the important role the US dollar plays in both the US and international financial systems as the world's reserve currency. Brookings Institution senior fellow in Economic Studies and director of the Hutchins Center on Fiscal and Monetary Policy David Wessel moderated the discussion with panelists Antoine Martin, Swiss National Bank governing board member, Robert McCauley, nonresident senior fellow at Boston University and associate faculty at the University of Oxford, and Fabio Natalucci, International Monetary Fund deputy director of monetary and capital markets.
Transcript
David Wessel: Welcome back from lunch. I hope everybody is well rested, and very attentive. We're going to talk in this next section about the international role of the US dollar. It's a bit of a hybrid session. Bob McCauley has a paper, so he's going to speak about the paper, and then my other panelists, Fabio Natalucci and Antoine Martin, are going to talk about related topics. Maybe they'll respond to the paper again.
This is obviously a very timely topic, so timely that the Atlanta Fed conference coincides with a two-day conference at the Federal Reserve Board in Washington that's called the International Roles of the Dollar. What you see here is the people who the Fed Board wanted but couldn't get because Atlanta had already booked them. [laughter]
It's also timely because I hear a lot these days, mostly from people in the markets, who are worried either about the federal debt or about sanctions, who try to convince me that this is the last act of the dollar and that basically we're three weeks away from becoming the British pound. What's really interesting about Bob's paper and some of the comments that Antoine and Fabio have is just how extensive, in ways that I hadn't realized, the dollar has become used. To quote something Bob said: I don't know if this is in his paper, I read it in an interview: “The risk is not that the rest of the world is de-dollarizing. Rather, it is that the rest of the world continues to use the dollar, but politics may prevent the Fed from backstopping that usage. Nowadays, even US strategic rivals depend on the dollar.” So that's kind of the theme of this session.
Another theme of this session is, either there is life after you leave the Federal Reserve, or the Federal Reserve has a sinister strategy of placing its people all over the world. Bob McCauley was 14 years at the New York Fed and then 25 years at the BIS. He's working on a book titled The Domain of the Dollar, which makes him a perfect speaker at this event. Impressively, he's the coauthor with Bob Aliber of the eighth edition of Charlie Kindleberger's Manias, Panics, and Crashes, which was published in 2023, 20 years after Charlie died, although he still gets his name on the cover.
Antoine Martin is, since January 2024, one of the three members of the Swiss National Bank. He oversees the department that handles markets and foreign exchange. I learned something about the Swiss National Bank when I read the press release announcing his appointment. In the first sentence, before it says anything else about who he is or his qualifications, it says he's a French-speaking Swiss. That's important, which he could explain to you.
Also, one of the things I always find interesting about the Swiss National Bank: every once in a while, some lunatic member of Congress gets upset because the Fed is losing money, but really, who cares? Except in Switzerland, they care because they pay dividends to the cantons and they haven't been getting their dividends lately, so that is an extra level of pressure. Antoine spent more than 18 years at the New York Fed, and before that, four years at the Kansas City Fed.
Fabio Natalucci, who's the deputy director of the Monetary and Capital Markets Department at the IMF, where he's been for seven years and is the author of the best-selling GFSR chapter on private credit, which I highly recommend. Before that, he was 16 years at the Federal Reserve Board. There you have it. The Fed is everywhere. With that, Bob, the floor is yours.
Robert McCauley: Thank you, David. Good afternoon. I very much appreciate the invitation from President Bostic and his colleagues to present this work on the offshore dollar and US policy. My punchlines, right from the get-go: tens of trillions of dollars are borrowed outside the United States. US policy, in some ways, encourages the dollar to move offshore.
In 2008 and 2020, in the face of runs on the offshore dollar banking system, the Fed lent dollars through central bank swaps to banks abroad, and not only promoted global financial stability, but also made its own monetary policy effective. In 2020, the new element was the bond market crisis, and the Fed's purchase of domestic corporate bonds also did double-duty, stabilizing the market for dollar bonds issued abroad.
Looking forward, the Fed swap lines continue to cover a high fraction of offshore dollar borrowing. Thus, by swapping dollars with its central bank partners, the Fed can backstop global dollar funding markets.
Offshore borrowing of the dollar is big. How big? Well, let's consider nonbanks outside the United States, this is by residence, and there's about $13 trillion of debt by such nonbanks. Most of it these days is bonds, in blue. The rest is bank loans.
Moving on to dollar liabilities of banks headquartered outside the United States, henceforth “non-US banks,” we see they have $16 trillion of dollar liabilities. You can see in the left panel there, that most of that in blue is outside the United States, and about $3 trillion inside the United States, both at branches and subsidiaries. That makes for $13 trillion owed by non-US banks, outside the United States.
Though after the session yesterday morning, you may wonder exactly what it means to say this. I will say it, that the $3 trillion in the US has, in principle, access to the Fed's discount window. That blue area, however, is outside the United States and enjoys no such access.
That's the on-balance sheet dollar debt outside the United States, but then there's the off-balance sheet dollar obligations, mostly outside the United States. Now, in a market called the foreign exchange swap market, you basically borrow dollars with collateral of foreign currency. You all know the repo market. There, you borrow dollars with collateral of securities. Repos are on-balance sheet, but FX swaps are buried in the footnotes. They're off-balance sheet.
Now, to fix ideas, consider a Dutch pension fund. It has liabilities in euros, and so when it buys a US Treasury or a US bond in general, it's likely to swap its euros for dollars in the spot leg, and then in the forward leg it will sell the dollars for euro. That means it can fund the holding of the US bond, but also have a hedge that brings it back into euros and thus matches its liabilities to its pensioners.
Now, a lot of this kind of hedging goes on at a very short-term basis, so the bond may be long but the swap is short. That kind of churn produces no less than $3.5 trillion of daily turnover in the dollar foreign exchange market, the last time it was measured by the BIS. A lot of maturing swaps are getting rolled over every day.
Now, that's the sort of flow. The stocks here are very big. Nonbanks outside the United States: $26 trillion in dollar obligations to pay in FX swaps and forwards in mid-2022. You'll recall, that's about twice their on-balance sheet debt. For their part, the non-US banks owed about $39 trillion as a stock, more than twice their on-balance sheet dollar debt.
I trust I fully justified the claim that offshore dollar borrowing is big. Oddly, US policy has encouraged and at times supported the offshore dollar. We're talking here about a patchwork of policies with many unintended consequences. Probably the biggest single source is regulatory arbitrage. In the old days, Regulation Q said you could only pay so much interest on a deposit in the United States, and when one of the first eurodollars came into existence in 1955, a bank in London could pay above that maximum rate and get a dollar deposit.
Probably over time, and very important until 1990, were reserve requirements. The Fed had unremunerated reserve requirements. You could lose your job at the Fed in the old days by calling that a “tax” in public, but that's what it was. It was a tax. It was a funny sort of tax, because the higher inflation was, and the higher interest rates were, the higher the tax rate was. You can imagine it got more and more costly to hold a large denomination deposit in New York in the ‘70s as compared to putting the same money, with much the same risk, with perhaps the same bank, on a consolidated basis in London. Typically the depositor got the benefit of being willing to move a deposit from New York to London. The question we used to ask is, why does anyone hold a US CD when she could get more on the same money, much the same risk, in London?
But that's not all. The work with Catherine Schenk, through the archives, we found that in the late 1960s the people at the New York Fed could see a funding squeeze about to happen in London, the same sort of end-of-year effect we have even today. What was done was that the Fed would forward dollars to the Bank for International Settlements, and the dealers in the banking department at the Bank for International Settlements would place the deposits—naked, without any collateral—in London banks, and keep the overall level of rates in London from going up.
These sorts of operations, a handful of them in the course of the late ‘60s, really were a precedent for what we'll see happen in 2008 and 2020, where the swaps have nothing to do with managing exchange rates as they often did from the early ‘60s on, but instead had everything to do with funding offshore banks in dollars.
Another interesting case: in 1974, the number 23 bank in the country, a Long Island bank called Franklin National, got into trouble on foreign exchange deals and went to the Fed's discount window. The Fed ended up lending against all the collateral that Franklin National had in the United States, and the Fed went beyond that and lent against collateral from London. In fact, the branch in London took the collateral to the Bank of England, where it was held in custody for the Fed. There we had a kind of internationalization of the discount window and dollars being advanced to pay off depositors in London, secured by claims on others booked in London.
Just as a final, there are more in the paper: typically, the US authorities have tried to avoid losses to uninsured depositors offshore in US chartered banks, not just in the case of a big bank like Continental Illinois, but even in the case of some very small banks. Yet, it seems, if I understand things correctly, that some of the depositors in the Cayman Islands branch of Silicon Valley Bank were not included in the otherwise general support for depositors, even large uninsured depositors, in Silicon Valley Bank. If anyone knows of other cases of a depositor in a branch of a US bank outside the United States not recovering 100 cents on the dollar, I'd like very much to hear about it.
Now we move to the crises of 2008 and 2020. We have basically runs on the offshore dollar banking, and the Fed's lending through swaps to non-US banks abroad did double duty. As I say, it promoted global financial stability meeting a run, but it also promoted domestic monetary transmission. We'll see how.
The Fed supported the dollar funding of non-US banks in 2008 in three different ways, broadly, in three different stages. The slow run started, it was referred to this morning, in August 2007, when a French bank said it had this fund full of US mortgage securities, private label, that it couldn't value anymore. At that point, you looked at the other bank that you had money in and you wondered how much of such paper it was holding, what kind of valuation it was placing on it, and a slow run started on many non-US banks.
By December 2007, the Fed rolls out an adaptation of the discount window called the Term Auction Facility, which was designed as a stigma-free discount window. Auctions were held; lots of banks participated. There was safety in numbers. You weren't individually going, cap in hand, to the discount window. You were part of an operation getting money at a good price.
In parallel operations, there were Fed swaps to the ECB and the Swiss National Bank that funded what the director of operations at the ECB at the time, Francesco Papadia, called the “13th District operations.” These were dollar loans by the ECB to banks in the euro area, against generally euro collateral, so the Fed provides dollars to the ECB, the ECB writes up a euro deposit for the Fed. The ECB turns around with the dollars and distributes them to needy banks in the euro area and gets in return euro-area collateral.
This is a convenient arrangement from the standpoint of the Federal Reserve because it gets the dollars out quickly. That keeps interest rates from being pushed up in the morning before New York even opens up and creating a problem for the Fed and the fed funds market, but the ECB is the one on the hook for the credit and the collateral risk in terms of the dollar loans to the many banks. It's the ECB's problem to know the banks, to know the collateral, to take those risks. That's the division of labor, a sort of condominium effort.
Things took a bad turn, of course, with the Lehman failure. A money market fund broke the buck, and a fast run broke out against the whole group of money market funds, so-called institutional prime. That was also a run on non-US banks, because they depended very heavily, for more than a trillion dollars, on such money market funds for their dollar funding. At that time, the Fed and the Treasury both provided emergency support to money market funds, with the Fed buying up commercial paper, later even underwriting new issues of commercial paper, the Treasury guaranteeing the buck, as it were.
But the damage had been done to the non-US banks. They had lost a great deal of funding, and the central bank swaps were the way that they were replacing the money that they were paying back to the money market funds that were in turn paying off their shareholders. To meet the runs on the non-US banks, the central bank swaps increased in size, maturity, participation, progressively, over September into October of 2008. On October 13th, it was announced in the middle of the night that swap amounts provided to the major central banks would be there to accommodate whatever quantity of US dollar funding is demanded.
Instead of having a limit of $30 or $60 billion for the swap line between the Fed and the ECB, it was going to be a matter of accommodating whatever the banks participating in the ECB operation could produce the collateral to demand. The limit on the size of the operation was no longer what the central banks were willing to do with each other, but rather how much collateral the banks that needed the dollars could produce in euros.
This is where we come from the financial stability aspect, the meeting of the run, to the US monetary transmission part. As the funds started flowing in, in very considerable size, three-month LIBOR—which is the benchmark for adjustable-rate mortgages, which were then not pervasive but much more popular than today—the benchmark for corporate loans, that LIBOR, fell from almost 6 percent in mid-October to half that level in November. This is the picture there.
In the wake of the Lehman Brothers failure, there had been this steady upward ratcheting of LIBOR from 3 percent up to 6 percent. The dotted blue line represents OIS, the overnight index swap, a sort of three-month outlook on overnight rates. It was going down as the prospect of the Fed easing in the face of the crisis got stronger and stronger, and the spread between the black line and the dotted blue line widened to a peak, just before this fateful day of October 13th, to almost 5 percent, but was down by the end of the year to 2 percent as the funds flowed.
What was happening with the swaps and the money going out of the Fed to the ECB and others, into the banks, was coming back into the US monetary transmission as a convergence between the rates that the Fed was setting and the rates that households and businesses were paying. We fast forward to March 2020. Again, non-US banks lost dollar funding. Why? Well, there was a dash for cash, and that includes redemptions of holdings of prime money market funds, even though none of them broke the buck on this occasion.
Non-US banks' liabilities to money market funds dropped by $200 billion in days. Again, the Fed used its emergency powers to buy and underwrite commercial paper supporting the money market funds. Again, LIBOR starts to rise, despite the obvious prospect of the Fed easing, and the Fed steps up to the plate very quickly and the pricing of the central bank swaps is reduced. The spread over OIS, their tenor is lengthened, then nine other central bank swaps are added to the five standing swap lines that dated to 2013, the major banks.
Once the daily swaps began, LIBOR peaked and declined within weeks. It's a much less dramatic picture, in part because of the speed of the reaction. Of course, businesses and households in the United States again stood to benefit from LIBOR not ratcheting up, even as activity dropped and people sheltered at home. You can see the first step there in mid-March, with the five core central banks' pricing going down to OIS plus 25 basis points. Long-term, 84-day swaps, nine central banks added days later, and then the daily operations start, the spread again peaks and comes down. We need to understand that what was going on here was not only an international operation intended to promote global financial stability, but also one that was succeeding in keeping US monetary transmission working.
Now, in the 2020 bond market turmoil, other things were going on, so 2020 was not just a repeat of 2008, we had huge selling of Treasuries by hedge funds, by foreign central banks, by open-ended bond mutual funds in the United States, as there was a reaction to price declines of the funds. The Fed eventually takes the unprecedented step of coming in as a corporate bond buyer of last resort, again invoking emergency powers. This does, again, double duty. It stabilizes not only the US corporate bond market, but also the global dollar bond market. I'll show you that first in prices, and then in flows.
Here's prices, and the first step that is consequential here is that the Fed uses its emergency powers to fund the primary dealers against assets that usually the Fed does not operate in, including corporate bonds. That alone sort of broke the fall of prices of US corporate bond ETFs in blue, and the MB, the emerging market bonds, dollar bonds, in black. You can see they move quite a bit together and recover as the Fed then announces later in March that it will buy US corporate bonds. Eventually, it also announces that it will buy junk bonds. The flows similarly turn around as the Fed makes the announcement that it will buy the US corporate bonds. This is a case of happy, unintended consequence. The Fed was doing something to add liquidity to the US corporate bond market but it actually succeeded in stabilizing the market for dollar bonds issued by all sorts of entities from around the world.
Now, remember, the Fed chose its swap partners back in 2008. It chose the same ones in 2020. There's a question of, in the intervening years, how does the selection look? Looking forward, the Fed swap lines reach banks and currency markets that account for a high share of offshore dollar borrowing, so the reach is still there. You've seen this graph. We focused on the left panel before. You'll remember the blue area is the dollar liabilities of non-US banks outside the United States. In the right panel, that blue area is decomposed by whether the country or the nationality of the bank has a swap line with the Fed or not. The bottom area there, the largest area, is the big five (Canadian, Swiss, euro area, Japanese, and UK banks). You see that's half to two-thirds of all the offshore dollar liabilities of non-US banks. You add in the five advanced economy swap partners that got temporary swap lines and add in the four emerging market economies that got temporary swap lines, and you're up to three-quarters.
So about three-quarters of the dollar liabilities of banks that are headquartered outside the United States are covered, as it were, by the swap lines. If we do the same sort of exercise with the borrowing of dollars in the foreign exchange swap market, it's an even higher level of coverage. In 2008, the Fed selected 14 central banks as swap counterparties. Turns out that 12 of those were central banks whose currencies were among the top 14 currencies traded against the dollar in the FX swap market. If your model was the Fed, you just sort of went down the list of the central banks with currencies that traded most against the dollar at the FX swap market. You wouldn't have a bad model at all.
If we go to the quantities, back in the data available in 2008, would be the left bar, and over 80 percent of the dollar borrowing in the foreign exchange swap market was against currencies whose central banks got a swap line. That has remained remarkably stable over the years, the latest survey in 2022 indicating still about five-sixths of the overall dollar borrowing in the FX swap market comes against currencies whose central banks have swaps with the Fed or at least had swaps in the case of the temporary swap lines. The blue bars there, again, are the five central banks with the standing lines with the Fed.
Question: It has been argued that there is this two-sided effect of the swap lines in 2008 and 2020, not only meeting the run, dealing with the financial instability, but also helping US monetary transmission. Now LIBOR has been retired, and it has been replaced by a new benchmark which is based on domestic repo. Why might the Fed backstop offshore dollar funding markets now? Clearly, US monetary transmission is much less exposed to offshore dollar funding strains these days because the repos, the prices that go into the SOFR, are domestic. Besides, there's a Fed standing repo facility that was alluded to yesterday, that could limit any response of the repo market in the US to any turmoil in the global dollar funding markets.
I contend that if monetary transmission is less the issue, that US financial stability very much remains the issue. If strains in the offshore dollar funding markets were very significant, they could lead to cutbacks in the global dollar credit supply, and that would necessarily affect borrowers in the United States. If we go back to that Dutch pension fund, what would happen if it came to the FX swap market and found it could not roll over its hedge. What might it do? One of the things it might do would be to sell the US dollar bond, and take the dollars, and pay off the maturing swap. That could even occur at fire sale prices. In these cases, the Fed lending dollars through the central bank swaps could promote financial stability at home.
With that thought, let me conclude that the dollar's role as leading international currency, with some help from US policy over the years, features large dollar borrowing offshore. In response to runs in 2008 and 2020, the Fed channeled dollars through central bank swaps to non-US banks abroad and brought down the benchmark lending rate for US borrowers. Now, those Fed swap lines, the actual standing ones and perhaps the other formerly temporary ones, those could still reach a high share of offshore dollar borrowing, both by non-US banks and in the FX swap market. In the event of severe strains in the offshore dollar funding markets, the Fed's dollar lending through central bank swaps can promote both global financial stability and domestic financial stability. Thank you.
Antoine Martin: First, let me thank the organizers for including me in this wonderful conference. I also want to thank my colleague, Miko, who helped me prepare this presentation. My plan for today is to give some brief remarks about Bob's paper. Overall, I thought the paper was really excellent and I agree with the big picture story. What I'm going to try to do is sort of compliment the paper by talking about another way that the Federal Reserve is able to provide dollar liquidity abroad, and that's through the FIMA repo facility. I'll provide a case study of what the SNB did in handling the Credit Suisse liquidity crisis, because the SNB used the FIMA swap line. I'll conclude with some brief lessons learned.
The paper is really good. I recommend it to everyone. It chronicles the joint evolution of offshore US dollar money markets, and then policy measures taken to stabilize this market. The main thesis of the paper is that the system of central bank swap line supports the functioning of the offshore dollar money market, in part by strengthening the ability of foreign central banks to act as lender of last resort. Basically, I agree with Bob's main thesis. So again, my presentation is really going to be about complementing this analysis and adding pieces that are particularly interesting or relevant.
Two quick suggestions. One is sort of picky, but Bob had to choose some cases or illustrations. Perhaps there are others that would be useful. One example is the post-9/11 use of the swap line between the Fed and the ECB. You discussed the corporate lending during 2020. There was also lending to money funds that also had similar benefits, so those are things that could be added.
The more important part, which is going to be related to the rest of my presentation, is to clarify the purpose of the swap line. My understanding is that the primary purpose of the swap line is to counter severe global dollar funding strains. In contrast to what appears in some of the paper, at least in the version I got, is it's not designed to enable the Fed to act as an international lender of last resort. Arguably, with the swap lines or with FIMA repo, the Fed never lends to commercial banks. It only provides liquidity to other official institutions. This distinction is quite important to make. This is really not about the Fed being a lender of last resort in the traditional sense of lender of last resort. It's really about strains in dollar funding markets. The interesting thing is that it helps other central banks play their lender of last resort role.
What do I mean by that? I imagine that in this gathering, most of you are familiar with the Bagehot rule, right? Bagehot, way back, provided this rule for central banks to lend quickly and freely at a high rate against good banking securities. Now, of course, in Bagehot's time but until very recently, what central banks had to worry about is lending in their own currencies. This is different today, so in a world where there are very large dollar markets abroad, a number of banks, certainly G-SIBs, but potentially other large, globally active banks, have large portfolios in other currencies, particularly the dollar. That means that if a central bank needs to play its role as a lender of last resort, particularly again for G-SIBs, it needs to be able to provide dollars to the banks that are suffering from a liquidity problem. How do you do that? Well, one way to do that is the swap line, another way is to use the FIMA repo.
There was a recent example, a recent unfortunate example, of a central bank, the Swiss National Bank, having to lend a large amount of liquidity to a bank suffering from a funding crisis. Let me give you sort of a super high-level summary of what happened during the Credit Suisse crisis in March 2023. At the end of 2022, Credit Suisse was still one of the 30 G-SIBs. Like other G-SIBs, CS funded itself not only in Swiss Francs, but also in many other currencies, particularly the US dollar. In March 2023, it experienced a deep crisis of confidence from its investors and a sharp run on its deposit base. By the 20th of March 2023, the SNB had provided a resource with a ₣168 billion Swiss Franc equivalent, approximately $180 billion in emergency liquidity, and almost half of that was in US dollars.
For the Swiss National Bank to play its lender of last resort role, in the case of Credit Suisse, it needed to come up with a very large amount, almost $100 billion, in US dollars. In principle the SNB could have relied on the Fed swap line. Instead, what the SNB did is rely on the FIMA repo facility, and I wanted to talk a little bit about this.
First, what is the FIMA repo facility? It was first set up in late March 2020, at the height of the money market turmoil due to the pandemic. It's been extended twice, and it was made permanent in July 2021. Basically, it allows account holders, institutions like central banks and for institutions that have accounts at the New York Fed, to borrow, temporarily, dollars against assets that they hold at the New York Fed. The collateral is US Treasury securities, and so far, FIMA has been used heavily only once.
Here's a table. What are the similarities and differences between the swap lines and the FIMA repo? So again, these two facilities have a similar purpose. They allow foreign central banks to access dollar liquidity in large quantities. Now, the swap line is limited to a set of central banks that have a swap arrangement. The FIMA repo facility is open to a broader group, basically foreign official institutions that have an account at the New York Fed.
In both cases, the purpose is fairly similar: ease strains in global funding markets. For the swap line, it's an alternative source of US dollar for the FIMA repo facility. If you're a foreign institution like a foreign central bank, and you hold US dollars, if you hold US Treasuries, you could sell those Treasuries. This is something that was not a great idea in March 2020, and so the New York Fed is proposing, as an alternative, to allow you to borrow against, to repo against, these assets.
The collateral is slightly different. In the case of the swap lines, the other central banks can provide their currency in exchange for dollars. In the case of the FIMA repo, you have US Treasury sitting in the New York Fed. That's the collateral for the dollars you get. One of the important aspects of the Credit Suisse lending that I mentioned earlier is that the Swiss National Bank, because the Swiss National Bank does QE by purchasing a foreign currency, notably euros and US dollars, the Swiss National Bank is sitting on a large portfolio of US dollars, US Treasuries in particular, which it could use to obtain liquidity through the FIMA repo. That wouldn't be possible for central banks who don't hold large portfolios of US dollar assets. In this case, if you have access to a swap line, the swap line would be an alternate proposal.
Another important aspect is the delivery time. FIMA repo is designed to be a T+0 facility. In contrast, the swap lines are designed to be T+1. It is operationally possible to do it T+0, but that's not the way it's structured. In terms of currencies, in principle, currencies of all the participating central banks can be used. In the case of the FIMA repo, you have to have US dollar assets, Treasuries, sitting in the New York Fed in order to be able to take advantage of it. There's a number of differences that may make one facility more desirable than the other in specific circumstances. In the case of the Swiss National Bank, the Swiss National Bank was sitting on a lot of US dollar assets, US Treasuries, so that was particularly convenient. T+0 makes it very desirable. It's possible to obtain liquidity very, very quickly in a particularly difficult circumstance. Those are some of the reasons why the SNB chose to go in that particular direction.
At a high level, what have we learned from this crisis, and what have we learned in terms of provision of liquidity abroad, dollar liquidity abroad? Again, exercising the lender of last resort function over G-SIBs, this can involve having to provide a large amount of liquidity in both the home currency and the US dollar. This is somewhat underappreciated. If you are responsible for providing liquidity to a G-SIB and you're not in the US, you really have to think about how, operationally, you're going to have to do that because this is likely going to be a big issue, as the Swiss National Bank found out.
It's important to be operationally ready. In the end, everything worked well in the case of CS, and the Swiss National Bank was able to provide that liquidity, but that required quite a bit of communication at the operational level, and great teamwork with my former colleagues at the New York Fed. From the perspective of the SNB, in that case FIMA had a number of advantages. That doesn't mean that it's always the better facility, but certainly the fact there was no question asked, as mentioned before, the fact that there's no stigma, makes it particularly valuable. The SNB would have had access to both facilities. Of course, other central banks might not, and that could make the FIMA repo particularly attractive in a number of circumstances.
One more thing. This is not directly related to Bob's paper, but it seems important in general. The Credit Suisse event seems to be one more example of a wholesale funding of banks running much faster than most regulatory models seem to assume. With that, I'm done.
Wessel: Thank you. We have to note that Antoine arrived at the SNB afterwards. You were part of the cleanup crew, right?
Martin: I heard all about it, but I wasn't there.
Wessel: Were you on the other side of the transaction at the New York Fed?
Martin: I was not.
Wessel: Okay.
Fabio Natalucci: First of all, I want to thank President Bostic and the Atlanta Fed for inviting me. I have been here before, and it's always a pleasure to be back here and get away for a few days from the crazy life in Washington. I also want to thank them for the opportunity to actually read Bob's paper. Having spent a lot of time in monetary affairs at the Board, I always tend to look at those crisis times through the lenses of US financial markets. I sit in a very different job now, where actually what matters is the global side of it, in terms of both financial markets and financial stability. We're seeing through different lenses somehow the evolution of our lender of last resort, the Fed intervention, was actually really helpful for me to rethink some of these issues.
What I'm going to try to do, I'm going to organize my remarks around four buckets: one, the evolution of the market structure. The evolution of the policy support, and then more, going to questions. One, for example: if this is the new steady state, are there possible unintended consequences? I mean, this kind of intervention that went from a very well-defined segment of financial market in a specific institution, to a broad market support. Then finally, ask the question whether there's a need to rethink a little bit the policy framework in this new world.
Starting with the evolution, I'm not going to spend much time on the evolution of market structure. Bob showed some of those charts, and I'll highlight three points. One is the growth of non-US banks' dollar liabilities. That's a pretty remarkable increase over the last many years. The second one is the growth of non-bank financial intermediaries, or the NBFIs, both within the US but also in the rest of the world, including in emerging markets. If you look for some emerging market countries, passive, benchmark-driven, investment fund plays a significant role with implication for capital flows, exchange rate, and so on. That third point, the growth of bank lending to non-bank financial institutions; those are three factors that affect the way we should think about policy support in this world.
In terms of the evolution of policy support itself, I'm not going to spend too much time. The evolution has involved both the tools that have been used, as well as the scope and breadth of the policy support. From the ‘60s euro-dollar market, individual banking institutions—Franklin National Bank, Continental Illinois—using the discount window and repos, to the GFC, where the list of tools utilized was quite long, both with the focus on financial markets and financial stability as well as maintaining the effectiveness of monetary policy, including backstopping dollar funding markets globally.
We went from asset purchases that continue during the zero lower bound period to the discount window and the term auction facility, various emerging lending facility, liquidity facility focused on money market funds and the money markets more generally, and then the unlimited swap lines. Then with COVID, the objective was also to minimize the possible impact in terms of cost and availability of credit for both households and firms, in terms of the dash for cash. It included both the intervention that we have seen during the GFC on money markets, all the old liquidity facilities, the swap lines, but also tackling directly strains in bond markets. Not just dollar and agency MBS, but for the first time going into corporate bond markets, first by lending to primary dealers with the expectation and hope they will be on-lending to other institutions, and then subsequently straight into the corporate bond markets, including sub-investment grade.
If you think about this part in terms of the type, breadth, and depth of intervention, in my mind, this has been sort of a regime change. In terms of the magnitude, just looking at the size of the Fed balance sheet, but also in terms of the breadth of policy support. If you look at, for example, the composition of the asset side of the balance sheet. The support, in some sense, has evolved along two lines: one, the broader set of market participants that have benefited from support. Not just banks, not individual institutions, not just the banking sector, but increasingly nonbank financial institutions.
The second one, the broader set of markets and risk assets, from US Treasury, agency MBS, all the way to sub-investment grade credit. The other aspect is that the impact has been driven not just by the actual purchases themselves, but by the actual announcement of future purchases. That's where the role of communication and forward-looking guidance has become increasingly important, also going forward. In some of the discussion this morning on the balance sheet panel, I thought the part that was a little bit missing was the forward-looking part. A lot of the intervention is actually driven by communication itself.
The other point is that the impact on risk appetite has been global. Swap lines, spillover effect, it has gone beyond the corporate bond markets. Bob showed a chart on the IG (investment grade) energy market, so I'm going to try to convince you that the impact is broader. The chart to the left shows cross-asset performance, not just fixed-income assets, so US investment grade corporate (the red line) or US high-yield corporates (the yellow line), but also equities, MSCI global, as well as MSCI emerging markets, and even currencies for emerging markets. You can see the V shape with different speeds of recovery, but it takes the broad set of risk assets there, from equities to fixed income to emerging markets.
It's not just a portfolio substitution effect here, from Treasuries to corporates to 1-year corporate bonds, but it's a broad, much wider impact on risk appetite. Just briefly on the left, I'm not going to go through the individual bars here, but again, covering equities, EM currencies, as well as corporate credit, the impact is not just on the purchases themselves. All these markets were down, those are the red bars, but you can see that some of the positive support has occurred just at the announcement time, that's a yellow part, in between the first announcement and the last announcement, before the actual purchase occurred. That's where you go into the blue line, and then we get to the end of the year.
One other point to make, just in terms of looking at equities themselves but from a historical perspective. This is the major S&P 500 crashes going back to the Great Depression. The black line is COVID, then we have the dot-com bubble in blue, the financial crisis in red, and the Great Depression in gray. If you look at how much the S&P 500 dropped during COVID, it was down 34 percent in essentially one month. If you go to the GFC, for the equity markets to go down the same amount of decline, it takes eight months. One versus eight, not only the drop, but the recovery itself. The S&P 500 was back to the level of pre-COVID by August. We're talking about like a few months. It's a very quick decline and a very quick V-shaped recovery, completely outside of what essentially the purchases of the Federal Reserve with the announcement were. This is equities. This is not what was being backstopped directly by the Fed.
Now, obviously, these measures have been very supportive, have been paramount to restore financial stability and market functioning. Of course, it's not just monetary policy. Particularly for COVID, there's a role that fiscal policy itself played. I don't want to put all this on monetary policy, but clearly the impact is way beyond the actual market that the Fed itself intervened in.
Now, that takes me to the third bucket of possible issues, the unintended consequences or issues to consider. The idea is that the experience of this broad market support that goes beyond specific segments of market, specific financial institutions, and beyond the banking sector, can have implications in terms of possible unintended consequences or lasting effects. If you think about risk behavior, market participants, if you think of expectation for possible further intervention, both during crisis as well, in terms of monetary policy. In terms of market structure, what is the footprint of central banking markets? In terms of balance sheet composition, and so on.
I don't particularly like the word “moralizer.” I've never been a fan. The question needs to be asked whether incentives in markets... I look at this from the financial markets side. That's what I do on a daily basis. The question is, have incentives been fundamentally affected by expectation of additional support by the Fed and other central banks? That's what the markets called the Fed for. In a way, that's essentially what investors do. They minimize or misprice tail risk, right? Essentially, you get truncated distribution of asset returns.
Now, the next step in this direction is, have investors extrapolated from the responsiveness and willingness of central banks to provide forceful liquidity support during a crisis to more normal times in terms of what to do in terms of monetary policy? This is all the debate that's been going on now: how many cuts of the market pricing, vis-à-vis the dot plots in the SEP?
Another way to ask this question is whether price signals that normally would be derived by markets because of the truncation of the distribution of asset returns have been fundamentally distorted. I'm just going to show you a case that's not necessarily related to financial crisis, but the way, in my mind, markets look at this issue of policy support beyond the crisis themselves.
What I'm showing here in blue is an index of financial and policy uncertainty. Think about geopolitical uncertainty, as well as policy uncertainty. Then in orange is an average implied volatility, cross-asset volatility. That's an average between equities, effects, and high-yield credit. The green line is cross-asset correlation.
Now that correlation has come down. At the time we published the GFSR, the correlation was in the 90th percentile. That means, essentially, the asset price moved together historically, at the top end of the historical experience. The question here is, normally when the level of uncertainty—again, and this has come down, so it's less compelling now. With this level of uncertainty, one question would be: Where should volatility be? One would expect that the level of uncertainty would fit into implied volatility, our markets' price uncertainty in terms of option pricing. That volatility is extremely low. It's extremely low, and it is below the historical average, if you want. The asset correlation is very high, so that is essentially predicated on expectations that the Fed would cut. It was six cuts at the beginning, then it went down to one, now it's back to two.
That mentality, it's embedded in the way that investors look at this. Again, it's that truncation of the distribution of asset returns: that part could have more lasting impact on the way markets think about this. The reason I mentioned this is because one of the ideas that Bob had in the paper—I didn't put it up in the slides—was whether the swap lines that the Fed had...so the Fed would essentially, through swap lines, provide dollars to another central bank...and whether those dollars then could, for example, be used for asset purchases in other countries.
If that's the case, this issue about the incentive being changed, it would be not just the US, like in this case, but it would be much broader in terms of global markets how the risk appetite is looked at. Another issue is the balance sheet. I'm just giving the long discussion this morning. I'm just going to try to stay away as much as I can, so I'm not going to go into what is the steady state size of the balance sheet or composition. It is an issue, though, to consider. At least from the outside, in terms of public communication, there's been very little communication in terms of what is the steady state and what is the composition side. I'm not just thinking about the US. I'm also thinking about other central banks. If you think about the ECB, if you think about the Bank of England, where Bank of Japan is today, but also emerging markets. The important point is that emerging markets, for the first time during COVID, they actually employed asset purchases. That had never happened before. Some of this consideration—what is the steady state, what is the composition—may eventually be applicable to emerging markets, too, even though they have shrunk the balance sheet much faster than advanced economies in some cases.
There are still two questions in terms of the balance sheet. One is how central banks should manage potential losses, to the extent that only announcement works. In some cases, it could be that announcements themselves are not enough. The central banks need to go deeper into markets and do actual purchases. How should they think about potential losses, and how should they communicate? Because there are important political economy considerations, in terms of potential independence of central banks or whether this asset purchase may or may not be available as easily going forward, a time when markets expect the central bank to jump in every time.
The last question is how to think about communication. Who should central banks communicate to in terms of central bank evolution? How they should communicate and to whom, in terms of potential losses, and whether there is a need to consider some sort of medium-term solvency, even for central banks themselves. There's a discussion in some other jurisdictions on whether, for example, central banks should resort to the equivalent of retaining earnings. Whether they should have, in good times, to accumulate some money that can be used if there are losses. That discussion to me seems in the US is quite absent. It is a discussion that is starting to occur in other jurisdictions.
The last point, in terms of possible unintended consequences: NBFIs, or nonbank financial institutions, seem to be playing an increasingly important role, not just in the US, but globally. When there is broad market support, they benefit from central bank support themselves, despite the fact they are either at the perimeter of the regulatory perimeter, or even outside the perimeter.
Just to take home two points about the increasing interconnections with the NBFIs. The chart to the left shows US bank credit commitments to nonbank financial institutions. You can see that number has been growing and continues to grow. It's not one or two types of NBFI, it's a broad set of NBFIs. The second chart shows you the banks' cross-border linkages with NBFIs across jurisdiction, both in terms of claims themselves in dollars, or it's in share of liabilities. Those numbers, again, they continue to rise. It's not just interconnected between or within the NBFI world, but it's also linkages between NBFI and the banks themselves. A broad market support has implication well beyond the simple consideration of providing market support itself.
The last point I want to make is about policy support. Again, now we're going really into the “just questions.” I don't really have answers, but it's worth considering. One is, will central banks return to the pre-GFC framework of monetary policy and liquidity operations, or are we essentially in a new normal, where asset purchases and broad market support are part of the central bank toolkit both in terms of monetary policy operations as well as in terms of central banking?
The reason I mention this is because it looks like, if you look at 2008 and 2020, central banks have been going, and the Fed itself, steep. It's starting to go deeper and deeper into markets themselves. Where to stop? We call it, they went into high-yield DTFs. As I mentioned, emerging markets themselves have started to do QE. The demarcation between domestic impact and global impact is much blurrier now. Let's just think about the chart of the impact, not just on fixed income, but on equities themselves, and emerging market effects.
How to manage investor expectation of what central banks will do next time that there is a crisis. Will they try to front-run markets in a way that will effectively...I don't want to use the word “corner,” but push central banks to intervene, and deeper into this market? Also, what is the central bank communication at that time? That's become an important element of monetary policy strategy since the Great Financial Crisis.
Honestly, at times, at least from the outside, it looked challenging. If I think of the Bank of England LDI experience, for example. It was really challenging communication, at the time you're trying to hike interest rate because you need to fight inflation, but also you're trying to do asset purchases because you're trying to bring market functioning back into the gilt market.
Or a time even during the SVBs, there was a lot of discussion on how the Fed would handle monetary policy for inflation purposes versus financial stability purposes. How should the central bank communicate that? Is there a need for a framework to assess central bank policy liquidity provision when we move to a broader market support? For example, how to think about the trade-off between monetary policy and financial stability? In principle, the separation principle will call for I have two objectives, I have two tools. I can deal with financial stability either with the balance sheet or with macroprudential policy tools ex ante. At the time, even in practice, this has been challenging, but it's even more challenging when inflation is actually high because the interest rate actually pulls in two different directions, in terms of the two objectives.
Now, the question is, do we have other tools for this separation principle? Often, we have the fund as well. I'm a big fan of macroprudential policy tools. Those are more ex ante tools. They're more meant to prevent the buildup of vulnerabilities so that that trade-off can be lessened or mitigated.
The question is, do we have enough macroprudential policy tools? If you think of availability of macroprudential policy tools, the ones that exist that have been used in some jurisdictions are primarily about housing. There's nothing in the corporate bond market. The only example I could think of was the Banque de France, that has a concentration limit for banks, how much banks can hold in terms of corporate bonds, but it doesn't apply directly to the corporate bond market.
Then there's the issue of fragmentation. If you just look at the regulatory supervisory landscape in the US, it's a combination of agencies with different tools, different mandates, that is brought together by the glue that the FSAP is providing. FSAP has been designed, in some sense, with a different objective. How to think about, how can that fragment, and it's not just in the US, how that fragmentation could become an impediment to efficient and speedy support.
The last point on this is how to think about central bank liquidity to NBFIs. There's two or three types of NBFI liquidity support I could think of. One is what we call discretionary market-wide operation. Essentially, if there is a market functioning or financial stability issue and discretion under constraint, the central bank decides to step in and provide targeted temporary support.
Another type of support could be access to a standing lending facility by NBFI. I think Bank of England is leaning in that direction. That raises a number of questions of supervision and regulation if those NBFI have access to the central bank balance sheet, then the central bank as lender of last resort for NBFIs. In a specific case, specific institution, then the Bagehot principle should apply of lending freely, penalty rates, and collateralize.
Finally, the last question is, is there a need to rethink the supervisory regulatory perimeter in a world where central banks provide market support to financial institutions outside of the regulatory perimeter? Now, of course, it's important to acknowledge the steps taken since the GFC. Clearly, the banking sector was stronger. We have seen it through COVID, it was resilient. COVID was the first real stress test, if you want, of the financial system post-GFC. The banking system worked out well and remained resilient.
Of course, Credit Suisse, SVB, and other institutions here were a reminder that even if the banking as a whole is resilient, there could be a weak tail of banks that actually could become systemic, just in terms of mass of the institution itself. Then post-March 2020, they also need to rethink and finalize the regulatory form for NBFIs. Somehow the FSB picked up the topic very quickly after 2020, and then: does it really need to calibrate and finalize that?
I'm not calling for more regulation, just to be clear. The issue is three-dimensional here, it's disclosure and data, it's more improved supervision, then regulation itself if needed. I want to show you a chart here, just to conclude, just to get a sense of the complexity and interdependency. We published a chapter on private credit. I'm not going to spend time describing the chapter. The market has been growing very quickly. We are now north of like $2.1 trillion globally. These are loans to middle market firms provided by non-NBFIs, private credit funds, effectively.
About 75 percent of this is in the US, so it's really a US phenomenon, but it's a very complex ecosystem. It's enough you look at the one in the middle here. There are different types of end investors, pension funds, insurance companies, sovereign wealth fund, retailers. There are different types of funds. Most of them are closed-end funds. Some of them may be a different structure when they are market to retail. There are banks that provide portfolio loans to these companies, essentially leverage to private credit. Then you have the leveraged corporates at the bottom.
The way we looked at this was: What are the possible vulnerabilities? One is liquidity mismatch. Generally, it is not an issue. Those are closed-end funds, long liabilities, long duration, with the exception of the $100+ billion that is going to retail. There, it's a separate discussion.
Leverage. There are three layers of leverage: there is the corporates, there is the leverage provided by the banks, and there is the leverage employed by the investors themselves. Structured SPVs and structured finance that institutional investors are set up to include leverage in themselves. So, how to think about this layering of leverage, if you go into a deep recession.
Then there is the interdependence. If you look at this and think about stepping in and buying credit instruments, this is the ecosystem that central banks would be facing. In terms of who benefits from support, but also how that support percolated through the ecosystem and affect different parts of this ecosystem. That interdependency that includes private equity and insurance companies, it's very hard to assess. There's no data. It was a huge amount of work just to go to New York and talk to investors, because, as I said, factually there are no data. How that support would percolate through the system, it's something that we don't really understand or know.
Finally, it is primarily a US issue. There are cross-border implications. That's why the role of, if the Fed steps into this market, or credit more generally, it has implication globally. Why? Because North American private credit funds, they play a significant role in the rest of the world. That's the blue line, for the last three bars. So yes, it's largely US, but US firms, pick any US names you want, they actually land in Europe, they land in our jurisdiction.
The other aspect of cross-border is, some of the investors into the largest US fund are European institutional investors, Japanese institutional investors, Asian institutional investors. There are clearly cross-border implications to this, that when you step in and backstop this market, the central banks need to keep in mind. Thank you.
Wessel: Thank you. We covered a lot of ground here. We started out with the eurodollar market and suddenly we're at private credit. Bob, I wonder if I could just start with one big picture question for you. You explained in the paper very nicely how the eurodollar market grew. First it was arbitrage, as you said, then it was encouraged by the US. What is driving the continued growth of the use of the dollar outside the United States, and do you think it's going to continue inexorably or is there some limit that we're going to reach at some point soon?
McCauley: It's lost some of the impulses that it once had, the reserve requirements in the US, and yet it continues to grow. You saw on some of the graphs that things had tailed off recently, but I would submit that that's a function of the strong dollar making dollar borrowing less interesting, as a kind of cyclic observation. Is the eurodollar market growing faster than the US domestic counterpart? These days, it's very hard to say, but I certainly don't have a prediction that the eurodollar market is going away.
Wessel: Do you think that it's going to inexorably increase the use of the dollar at FX swaps and everything, or is it going to asymptote at some point?
McCauley: In general, if you think the rest of the world is growing faster than the US, which is less clear now that it looked some years ago, then you would say it'll grow relative to the US financial system.
Wessel: There are a couple of questions which are excellent questions, and I'm not sure if this panel is the right one to pose them. I'm going to pose them to you with the proviso that if you don't have anything to say, feel free not to say anything.
One question that came up from a number of people is, there was a little bit of noise about the Fed lending to foreign institutions when the disclosures were made about the discount window lending after the Global Financial Crisis. To a large extent, the extent to which the Fed has, if not become the lender of last resort to the rest of the world, then as Antoine put it, it'll become the lender of last resort to other central banks so they can be lenders of last resort in their own constituency. There seems to be very little political blowback so far in the US. Can you explain that? Secondly, if there were, how would you explain to our enlightened members of Congress that this is actually in the interests of the United States?
Martin: Obviously.
Wessel: I was just going to call on the audience in a minute but go ahead. [laughter]
Martin: The US benefits enormously from the fact that the US dollar plays the role of international currency, and there are US dollar markets abroad. Other than it's a complicated question that perhaps is not always answered...
Wessel: There are going to be benefits that I can, what, fund the federal debt more cheaply because we're the currency of the last resort? Is that the basic...
Martin: That's one example, yes, absolutely. Again, other than the fact that this issue is perhaps not super well understood in Congress, there are clear benefits to this country of having...
Wessel: My sense is that it hasn't got much political blowback because most people don't have a clue that it's happening. If they do, there will be some.
McCauley: I would note, David, that in Dodd-Frank there was a revisiting of 13(3), the emergency power provision, and restrictions on it. There was no such...clearly, when it came to the swaps, and clearly Chairman Bernanke got some going over by a Florida congressman who asked him why $9 billion for 3 million New Zealanders. He didn't even mention the sheep, an obvious laugh line. There was some resistance, but it didn't result...
Wessel: Somebody asked a relevant question, which was: Dodd-Frank does say that the Fed can't so easily lend to a single institution, but apparently that is not an impediment to the Fed lending to the Swiss National Bank to lend to a Swiss institution as best we can tell.
McCauley: Well, that wasn't 13(3). That was a repo that the New York Fed did.
Wessel: That's true. That's a very good point.
McCauley: Even the swap line was drawn in 2008 by the Swiss National Bank to fund a special purpose vehicle for UBS.
Wessel: If the Bank of England decides it's going to provide lender of last resort services to nonbank financial institutions in London, there's nothing to stop them from doing a swap line or a FIMA thing to get dollars to lend to a non-bank financial institution. We could have a situation where the US is lending to the Bank of England, and they are on-lending to a nonbank financial institution.
Natalucci: To the extent that the NBFI are brought into the active access the central bank's balance sheet, in principle, yes.
McCauley: We already have a situation where the swap lines are drawn, banks get money, and the banks hand on that money to pension fund or insurance companies.
Wessel: There's a question here that I think I know the answer to, but the fact that Bill Nelson asked it made me wonder whether I do know the answer. Bill says, “Collateral only matters if the borrower defaults. The Fed swap lines, he says, are collateralized by deposits at the borrowing central bank. How is that different from not being collateralized? I thought the collateral was the euros, not the deposits, right?
Wessel: No, but it's the euro. The Fed has a deal that the European Central Bank will provide the dollars when it needs to be repaid. The European Central Bank is taking the collateral risk, not the Fed, right?
McCauley: No, but Bill's asking about the deal between the Fed and the ECB, where the ECB is providing euros, as it were, as collateral to the Fed.
Wessel: If the ECB defaults on the...
Wessel: Yes, but why is that like the top ten things...
Natalucci: If the ECB defaults, then whatever losses the Fed has is not the issue there.
Wessel: He's saying why bother to take the...
Natalucci: You have a way bigger problem at that point.
Wessel: He's saying why bother to take the euros if you have the promise. The Fed actually charges for this. They make money on this. There's a spread.
Let's see. Trying to be fair to people here. Bob, in addition to the use of dollars in offshore money and capital markets, is there use of dollars in offshore payments systems? That is, are local currency and offshore dollar payments systems integrated abroad?
McCauley: There are dollar payments systems of limited range in places like Hong Kong, but the right way of thinking about it is: everything comes through the United States. That's the way the payment flows work.
Wessel: I see.
Natalucci: If you look at trade finance, for example, 80 percent is dollar now.
Wessel: Does any of the stuff we're talking about have any bearing on the debate about the use of sanctions by the United States, the efforts of the US government to use the fact that it has such control over the global financial system to punish, say, Russia, or someday some other country, seizing the Russian central bank reserves?
I guess there's two ways to look at it. One, does this whole network give us extraordinary reach, because so many people are dependent on dollars? I'm sure the US government could someday tell the Federal Reserve, “You can't lend to country X.” Or secondly, does it make people nervous about depending on dollars, and lead them to think, “If only they could come up with some alternative”? Does that have any relevance to this at all?
Natalucci: I'm going to respond indirectly.
Wessel: This is to say, Fabio is not speaking for the International monetary Fund.
Natalucci: I would very much like to stay out of the sanction debate. If you think about this from the dominance of the dollar, in terms of trade finance it's 80 percent. If you think about, I don't know, effects reserve is 60 percent, then the rest is euros and other US-allied parts of the distribution.
One question has been whether, for example, the increase in use of gold is related to this, so essentially, the non-US block started using gold as a way to diversify reserves. Then, the increase in gold has been particularly concentrated in the, if you want to call it...let's posit that there are three blocks: the US block, China block, and the nonaligned. That increase in gold has been more evident in the China block, if you want, and Gita Gopinath, the first deputy managing director, just gave a speech a few days ago.
That increase, though, has been relatively limited. China, for example, the gold went from less than 2 to a little bit more than 4. You see a decline in Treasury holdings, which is another maybe proxy for this. It goes from 45 percent, if I remember, to about 30 percent. There are valuation impacts there that you should consider as well.
Traditionally these moves away from the dollar, they're very difficult to do. There are operational issues coming up with a new payments system. There are operational, governance, infrastructure. Ultimately, there's a reason why a currency is the world currency. It's an issue of stability, it's an issue of debt to markets, it's an issue how it's being used in trades, most of commodities are still priced in trade. There could be a move. Usually this moves, historically, at the same pace of a glacier pre-climate change, not the current. So yes, you could see some moves, you could look into the...
Wessel: This has been a long standing, “someday the dollar's going to fall” thing.
Natalucci: Exactly. So again, even the change in gold from 2 to 4, it's...
Wessel: Some of that must be retail, in China, too.
Natalucci: There are also anecdotes that it could be not just the authorities, but it could be retail investors as well.
Wessel: Bob, if we are having this conversation five years from now and the US has continued to implement more and more sanctions using the financial system, do you think that will discourage people from relying so much on the dollar, or do you think they have no choice?
McCauley: To your earlier question, the fact that the payment flows go at least instantaneously through the US is the way that the fines have been imposed on the foreign banks that have dealt with sanctioned countries. There's work now by Arslanalp, Eichengreen, Linda Goldberg, and coauthor that suggest that sanctions are moving some reserve managers towards gold or away from the dollar. If you look at what's happened so far, the dollar has been on a sort of steady decline that Arslanalp et al noticed, since 1999, about a half a percent a year. It's hard to see, in the aggregate data, any evidence of people withdrawing from the dollar.
Martin: It's important to note, in this area of finance, like in many others, the huge network effects. The more people use the dollar, the more valuable it is. Now, it's possible that for geopolitical reasons, you could create enough of a critical mass somewhere else for that to change, but that's a really big lift. So of course, other countries, again for geopolitical reasons, might have an incentive to try to move away from the dollar, but they have to overcome the incredibly strong network effect.
Natalucci: Can I add one thing also? If you take it from a diversification, we've done the final survey a while ago on debt management's manager. There is a sense of the increased uncertainty, geopolitical uncertainty, risk of sanction. That's one thing that feeds into this diversification. There can be benefits from running an FX reserve more diversified. Those benefits, though, work only to the extent the international cooperation is still there.
If you use swap lines—not just the Fed's, but other countries' swap lines. If those break down and then you just diversify, those benefits are probably more than offset by those costs that, essentially, you brought to transform the global system into blocks that don't communicate with each other. The diversification, per se, it's positive, but in the right framework, in some sense.
Wessel: Related to that, could you speak briefly about the work that you've been doing at the Fund, you and your colleagues, on the extent to which you see some fragmentation of the world economy, and how that plays into this?
Natalucci: We have done work both looking at FDI, that's the research department, and on the financial side, which is what I oversaw. So maybe I'll focus on the one on the financial side. Essentially, we tried to look at what were the impacts of geopolitical tensions on financial flows, like portfolio flows. The geopolitical tensions here are measured as the distance, as is done in the literature, between the voting rights, say, of the US and China. One standard deviation of that, which is the equivalent of what we have seen between 2016 and last year, in terms of the voting pattern of US and China, has a negative impact on portfolio flows, about 15 percent of bilateral flows in terms of banking flows, and about 25 percent of portfolio flows, so debt and equities. Those are quite large numbers.
There's also a much larger impact on emerging markets than on advanced economies. The impact on emerging markets, it's about 2 or 2.5 percent of GDP, which is a pretty large number. There are other costs, too. There are costs in terms of capital flows, obviously. It becomes much more volatile, and there are costs in terms of the financial stability of the recipient countries' banking systems. Banks' funding cost goes up, their profitability goes down. From a macro standpoint, if you divide the world in blocks, you lose the ability to diversify shocks so you cannot diversify away if you're just dealing with a smaller group or country.
From a financial stability perspective, obviously, there are other considerations with sanctions and national security, so we stay out of that debate, obviously. To make the point that the financial fragmentation has some costs, and they are not small costs. They're actually quite sizable costs. You can add to those then the fragmentation payments system, for example, particularly payments systems that don't communicate among themselves. They are not interportable, they have different standards, they come with different financial regulatory standards. You get a fragmentation of the payments system and the cost can be quite large. We've done some work on a world where you move into, for example, FDI to emerging markets not being collapsing. FDI is very important for EMs, and they bring technology diffusion, for example. For those countries, the cost can be quite large. For low-income countries, it can be four times as large than normal-income countries, for example. That is the impact on the potential output for the world economy if FDI collapses and you don't have portfolio flows.
Wessel: You clearly whet people's appetite on private credit, so this is the last question we have time for. One question is: Fabio, how do you think about designing financial stability tools and objectives in private capital markets? Are there specific worries you currently have about financial stability risks in private credit markets?
A related question: In what parts of the nonbank financial system do you see the greatest US dollar appetite? I mean, private credit is much smaller than private equity or hedge funds. Who needs the dollars there? Two questions: how do we insulate ourselves against private credit?
Natalucci: On the first one, there's vulnerability so we focus on the one that I mentioned, so vulnerability at the borrower level. If you compare the borrowers vis-à-vis firms that borrow in the syndication market, or in the high-yield bond market, they tend to be smaller, more leveraged. There's more riskiness at the borrower level.
On the liquidity mismatch, I'm more comfortable apart from the retail piece, because the more or less they match, it's very hard to run on these structures. The leverage, I'm starting to be a little bit less comfortable because again, we have this layer of leverage which we had very little visibility into. Maybe they are okay, normal times, that the exposure of the banks' Federal Reserve number seems to be around $200 billion, with leverage one time or so. If there are no large numbers, I don't know.
However, the deleveraging, if it's done simultaneously, the different layers would play out in a deep, prolonged recession. This sector has grown very fast and never faced a deep recession. We just have no idea how it would play out. The counterfactual that they offer, that we were there to provide credit during COVID, to me, doesn't work because COVID, as we just said, the Fed backstopped the full market. I don't want to use this. Perhaps the most concerning is the one I showed, the interconnectedness. There are too many entities: banking, nonbanking, insurance, pension, private equity in the US, in Bermuda. It's very hard to map this ecosystem and get a sense of how the risk, at what speed it would move.
In terms of size, obviously, this is a fraction compared to private equity, for example. The way I will look at this, it's more under the same umbrella. There are big names on Wall Street. I'm not going to name them here, but they run these three businesses the same way, in a synergetic way. They run the product with their insurance companies' line first, and their private credit, and they use the revenue stream from payments from the insurance to invest in private equity, and then they fund those private equity firms to their private credit shop. That, under one umbrella, can be okay from a profitability standpoint. I just don't know, under stress, how that system would work out. The numbers there are way larger than probably...
Wessel: You're basically saying, “I don't have any great tools to offer,” but you're saying we need more data.
Natalucci: I would say I have zero tools.
Wessel: Zero tools, and not much more than zero days.
Natalucci: I don't want to go into that they should be regulated. That's not where I want to go. We should start with more transparency, more data. I need to be able to monitor and understand this. Whether there's a need for more intrusive supervision, I think personally, yes. I'm not ready to go into the regulation part. I don't think at this current juncture, there are financial stability risks, but they are growing really fast, and then they'll stop. The last question is, how to continue to grow like this. At some point, there's not enough middle market lending that you can do, and they're starting to call to partner up with banks and move into infrastructure or asset-based lending. Those markets are way larger than what we see now. If they move in that direction, this segment will continue to grow quite fast.
Wessel: I'm afraid we have to leave it there. Fortunately, we have a coffee break and we're free till 3:30. You're eligible to ask each of the panelists all the questions I didn't quite get to. With that, please join me in thanking Bob and the other two panelists.