Stitching Together the Global Financial Safety Net

The past three decades have witnessed significant growth in cross-border financial flows. This structural shift can, in theory, bring great benefits. Resources can be allocated more efficiently, risks can be shared across borders, and knowledge and technology can transfer with financial flows.

But, as the global financial crisis has shown, these flows are not without risks. Cross-border capital flows expose countries to the risk of a balance of payments crisis, foreign currency borrowing exposes banks and corporations to the risk of foreign currency liquidity crisis,  and governments are exposed to the risk of a sovereign debt crisis, especially where public debts and fiscal deficits are high and the government relies heavily on foreign investors.

The first line of defence against economic and financial shocks is having robust domestic macroeconomic, and micro- and macro-prudential policy frameworks. However, when crises do occur, an effective global financial safety net (‘GFSN’) ensures early financial support to prevent liquidity crises from escalating into solvency crises, and local balance of payments crises from turning into systemic sudden stop crises. Our recent paper, ‘Stitching Together the Global Financial Safety Net’, assesses the size and composition of the GFSN.

The current global financial safety net

Historically, the GFSN was made up of countries’ foreign exchange (‘FX’) reserves, with the IMF providing a global external backstop. This was supplemented by some small regional financing arrangements (RFAs). The financial crisis saw an unprecedented increase in total resources with central banks arranging bilateral swap lines, existing RFAs increasing their resources and new RFAs being set up, and the IMF’s overall resources tripling.

FX reserves

Globally, there are in excess of $10 trillion FX reserves. They are an excellent first line of defence, but they are costly to accumulate, they are distributed unevenly, and their extensive usage can send negative market signals; their accumulation can also lead to distortions to domestic economies with spillovers to the global system. 

Swap lines

The provision of US dollar swap lines by the Federal Reserve in 2008/09 played a significant role in reducing pressures in global dollar funding markets. However, extending swap lines is constrained by central bank mandates which are focused on domestic macro-economic and financial stability policies, limiting their potential availability.

Regional financing arrangements

There are eight major RFAs, with total resources of $1.3 trillion. They provide financing to prevent regional spillovers and add surveillance expertise. However, pooling risk at the regional level is likely to be ineffective against regional systemic shocks and many RFAs remain untested.

International Monetary Fund

The IMF has $1.3 trillion of resources, and sits as the ultimate backstop to the international monetary and financial system. Yet, over 50% of the Fund’s resources are temporary, and due to expire over the next two years, putting its future lending capacity at risk.  

Is the global financial safety net adequately resourced?

We applied a series of external balance sheet stresses to estimate potential calls on the GFSN. For emerging markets, we simulated a sudden stop shock, which resulted in portfolio and banking flows partially reversing. For advanced economies, we simulated a foreign currency liquidity shock to resident banking systems, and a sovereign debt shock. 

The good news from our work is that the resources of the GFSN, including both the IMF’s temporary and permanent resources, appear broadly adequate for all but the most severe shock scenarios. 

The bad news is that there are some individual countries, emerging and advanced, which do not have sufficient resources, given the risks on their external balance sheets, and which could, in a severe crisis, have financing needs that would be too large for the IMF to realistically fill.

Policy actions to strengthen the global financial safety net

Faced with a safety net which is adequately resourced in aggregate, but may be patchy for some countries, there are three sets of potential policy responses:

• Reducing potential calls on the GFSN by strengthening external balance sheets. 
• Securing the availability of GFSN resources by increasing FX reserves in some countries, and by securing a commitment by IMF members to maintain the IMF’s lending capacity at its current level.
• Improving the effectiveness of the current GFSN resources by granting broader access to IMF precautionary facilities, and by making sure the IMF works closely and cooperatively with RFAs.

A longer version of this post was published on the Bank of England’s Bank Underground blog.

Edd Denbee and Carsten Jung are economists at the Bank of England, and Francesco Paternò is an economist at Banca d’Italia.