International Liquidity and the Financial Crisis Most policy-makers did not anticipate the financial crisis of 2008. Nevertheless, in contrast to their performance during the Great Depression, central banks around the world, led by the Federal Reserve, acted decisively following the collapse of Lehman Brothers and provided huge injections of liquidity into the financial markets, thereby preventing a far worse out- come. International Liquidity and the Financial Crisis compares the 2008 crisis with the disaster of 1931 and explores the similarities and differ- ences. It considers the lasting effects of the crisis on international liquidity, the possibilities for an international lender of last resort, and the enlarge- ment of the International Monetary Fund after the crisis. It shows that there is no clear demarcation between monetary and macro-prudential policies, and discusses how central banks need to adapt to a new environ- ment in which global liquidity is much scarcer. william a. allen worked in the Bank of England from 1972 to 2004, where he was Head of the Money Market Operations Division, Head of the Foreign Exchange Division and Director for Europe. Since 2004 he has been an honorary senior visiting fellow of Cass Business School in London and has published widely on central banking and international finance. He is a specialist adviser to the House of Commons Treasury Committee and a consultant to the International Monetary Fund. International Liquidity and the Financial Crisis William A. Allen cambridge university press Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Mexico City Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9781107030046 © William A. Allen 2013 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2013 Printed and bound in the United Kingdom by the MPG Books Group A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data Allen, Bill, 1949– International liquidity and the financial crisis / William A. Allen. p. cm. Includes bibliographical references and index. ISBN 978-1-107-03004-6 (hardback) 1. International liquidity. 2. Financial crises. 3. Global Financial Crisis, 2008–2009. I. Title. HG3893.A45 2012 332′.042–dc23 2012024503 ISBN 978-1-107-03004-6 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. Contents List of figures page vii List of tables ix Preface xiii 1 Introduction 1 2 The domestic liquidity crisis in the USA 12 1 The flight to liquidity and safety 12 2 The collateral squeeze 14 3 Commercial bank balance sheets after the Lehman Brothers failure 18 4 Secured funding and the liquidity management of large broker-dealers 20 5 Central bank reserve management 27 6 The collateral squeeze and the inflow of funds from abroad 30 3 International liquidity crises outside the USA 32 1 International flows of funds during the crisis of 2008 32 2 Currency-specific liquidity shortages 33 3 The unwinding of carry trades 41 4 The scale of the global crisis 43 4 Effects on financial markets outside the USA 49 1 Money and swap markets 49 2 Incidence of currency-specific liquidity shortages – evidence from market indicators 52 3 Effects of the unwinding of carry trades in destination countries 61 5 The theory of central banking before the crisis and the practice of central banking during the crisis 68 1 Pre-crisis central bank behaviour 68 2 The nature of central banks’ reactions to the crisis 74 3 Scale of central banks’ reactions 77 v vi Contents 6 Swap lines 83 1 History 83 2 Which swap networks were set up during the crisis? 86 Appendix to Chapter 6 96 7 Which countries received swap lines? 99 1 Risks to liquidity providers 99 2 Objectives of liquidity takers 103 3 Relationship between currency shortages and probability of receiving a swap line 104 8 Did the swap providers achieve their objectives? 113 1 Experiences of swap providers 113 2 Comparison of the experiences of swap providers 126 9 How did the swap lines affect the recipients? 128 1 Large international financial centres 128 2 Smaller international financial centres 137 3 Countries which are not international financial centres 144 4 Summary 156 10 Propagation and scale of the 1931 crisis 158 1 International flows of funds in 1931 158 2 Flight to liquidity and safety 164 3 Central bank reserve management 166 4 The scale of the liquidity crisis 168 11 The management of the 1931 crisis 173 1 The gold standard in theory 173 2 The gold standard in 1931 175 12 A comparison of 1931 and 2008 186 1 Nature and scale of the crises 186 2 Propagation and management of the crises 189 13 International liquidity management 197 1 Reserve-holding behaviour since the end of Bretton Woods 197 2 The effects of the crisis on reserve-holding behaviour 201 3 Post-crisis reserve accumulation 210 4 The global demand for liquidity and the concept of monetary policy 211 Data appendix 217 References 227 Index 240 Figures 1.1 The ‘TED spread’ page 3 1.2 World activity indicators 4 2.1 Central banks’ total assets, 2007–09 13 3.1 BIS reporting banks’ local claims in foreign currencies vis-à-vis all sectors 36 3.2 BIS reporting banks’ cross-border claims in foreign currencies vis-à-vis all sectors 37 3.3 Net outstanding US dollar cross-border claims on BIS reporting banks by economies shown 38 3.4 Net outstanding euro cross-border claims on BIS reporting banks by economies shown 39 3.5 Net outstanding Japanese yen cross-border claims on BIS reporting banks by economies shown 39 3.6 Net outstanding pound sterling cross-border claims on BIS reporting banks by economies shown 39 3.7 Net outstanding Swiss franc cross-border claims on BIS reporting banks by economies shown 40 3.8 Net outstanding cross-border claims on BIS reporting banks by groups of emerging economies shown 40 4.1 Covered interest rate differentials against the US dollar, three-month maturity 53 4.2 Covered interest rate differentials against the euro, three-month maturity 56 4.3 Covered interest rate differential of the won against the yen, three-month maturity 58 4.4 Cross-currency basis swap spreads against the US dollar, one-year maturity 58 4.5 Cross-currency basis swap spreads against the euro, one-year maturity 59 4.6 Cross-currency basis swap spreads against the US dollar, one-year maturity 60 vii viii List of figures 4.7 Exchange rates against the US dollar 61 4.8 Exchange rates against the euro 62 4.9 Exchange rates against the Swiss franc 63 4.10 Exchange rates against the yen 63 4.11 New Zealand dollar trade-weighted index 64 4.12 New Zealand short-term interest rates and bond yields 64 4.13 Swiss franc value of ‘other foreign currency’ housing loans to individuals in Hungary 66 4.14 Swiss franc value of foreign currency housing loans to individuals provided by Polish MFIs 66 6.1 Swap networks created in 2007–09 87 8.1 US commercial banks’ net debt to related foreign offices and Fed swaps outstanding 117 8.2 Use of SNB repo facilities by domestic and foreign banks 122 8.3 Nominal effective exchange rate indices 123 9.1 US dollar auction allotments 131 9.2 Foreign holdings of Korean local-currency bonds 145 9.3 Net position of foreign residents in Mexican government securities, 2006–09 149 9.4 Foreign holdings of Hungarian local-currency government securities 150 10.1 Gold stock and net holdings of foreign exchange 167 13.1 World foreign exchange and gold reserves as a percentage of world gross product 198 13.2 Quarterly changes in world foreign exchange reserves, 2000–11 208 Tables 2.1 The balance sheet of a shadow bank page 15 2.2 US commercial banks: changes in selected balance sheet items from 3 September 2008 to end-December 2008 19 2.3 Condensed balance sheet of Morgan Stanley, 2007–08 23 2.4 Morgan Stanley’s identified net collateral position, 2008–09 25 2.5 Bank deposits in foreign exchange reserves, 2007–09 29 3.1 Exchange rate-adjusted changes in commercial banks’ net external liabilities in the second half of 2008 33 3.2 Reporting banks’ local assets in foreign currency, end-December 2008 35 3.3 Selected assets and liabilities of banks located in Japan – changes from end-July 2008 to end-December 2009 42 3.4 International short-term indebtedness, 2008–09 44 3.5 Significant falls in bank deposits, 2007–10 46 3.6 Changes in bank deposits in and around the 2008–09 financial crisis 47 4.1 Average covered interest rate differentials versus US dollar, 16/09/2008–02/01/2009 55 5.1 Central bank official interest rates, 2008 78 5.2 Changes in central bank assets, 2008–09 79 6.1 Language of swap announcements by the People’s Bank of China 95 7.1 Results for probit and logit models by currency 106 7.2 Probit model for probability of receiving US dollar swap line 108 7.3 Probit model for probability of receiving US dollar swap line, taking into account time zone difference 110 ix