Comment 85: What is “Expanded Currency Swap Agreement”? A “Bernanke Plan” To Wrap Up Euro Crises Temporarily? A Twisted QE3? (December 7, 2011)

Introduction

The announcement of the “Expanded Currency Swap Agreement” on November 30, 2011 had sent Dow Jones Industry Average to soar near 500 points in one day. Many readers probably want to know why such an excitement in the stock market. In this article we will explain what is this “Expanded Currency Swap Agreement” and what will be its impact and implications.

What is the “Expanded Currency Swap Agreement”?

The adjective “Expanded” means that there is a “Currency Swap Agreement” in existence between US Federal Reserve (abbreviated as FED) and Euro Central Bank (abbreviated as ECB). The existing currency swap agreement with a swap rate of 1.0% will expire in early 2012, so the expanded agreement extends the life time of the agreement to the middle of 2013. The next step of the expanded agreement is to include four more central banks into the agreement, they are, Japan, Switzerland, UK and Canada. The final step taken by the expanded agreement is to lower the swap rate to 0.5% from 1.0%.

We should note that the inclusion of other four central banks is just a mirage to portray the agreement as an international effort. The essence of this expanded agreement is still the swap between FED and ECB. “Currency Swap” means literally that two central banks exchange currencies. In this case what is going to happen is that FED will give certain amount of Dollar to ECB and in exchange ECB will give a matching amount of Euro to FED. Also should be noted that the expanded swap agreement is open ended, meaning that there is no upper limit of how much currencies can be swapped.

Many readers at this point will ask, if “currency swap” is just the exchange of currencies between two central banks, then why should there be any “swap rate”? The answer is “currency swap” is also a smoke and mirror expression to conceal the real nature of the action from public eyes. What actually is going to take place is that ECB wants to borrow Dollar from FED with Euro as collateral. Thus ECB must pay certain interest for its Dollar-borrowing, and this interest rate is called “swap rate”. In the expanded agreement the interest rate that ECB pays for its Dollar-borrowing is lowered to 0.5% from 1.0% in the old agreement.

The next question will come up is, “why ECB wants to borrow Dollar from FED?” The answer is that many European banks are desperately wanting to borrow Dollar. We will not discuss the reason why European banks want to borrow Dollar in this article, and just ask readers to take the statement as the matter of the fact.

European banks go to London Inter Bank Market to borrow Dollar. The interest rate for such Dollar borrowing is called LIBOR, standing for “London Inter Bank Offer Rate”. The quoted LIBOR is, of course, the average rate. Less credit worthy banks need to pay higher rate than the average rate to borrow Dollar and vice versa. On November 29, 2011, just before the announcement of the expanded agreement, 3 month LIBOR was at 0.523%. On July 29, 2011, 3 month LIBOR was 0.254%. The rapid rise of this LIBOR is due to the worsening Euro crises. If the LIBOR keeps going up, eventually some European banks will not be able to borrow enough Dollar and will go down. Since the whole OTC derivative system is resurrected by QE1 and QE2, the failure of some European banks will bring down the global financial system rapidly, like a house of cards when one card is withdrawn. The expanded swap agreement is aimed to stop the rising of LIBOR toward 1.0%, the old swap rate. To understand how the agreement will work, we need to look into the mechanism how ECB is going to pass the swapped Dollar to European banks.

When ECB obtains certain amount of Dollar through the swap agreement, the dollars are auctioned To European banks. The banks submit bids detailing how much Dollar they are willing to borrow at what interest rate. The auctioned dollars are allocated to the highest bidders first, and go down the bid ladder until all the dollars are borrowed by European banks. If the amount of Dollar auctioned satisfy the demand of European banks, then those banks do not need to borrow through London Inter Bank Market and LIBOR will be capped. However, if the amount of Dollar auctioned is not large enough, the average borrowing rate of Dollar from the auction will rise, European banks still need to borrow from London Inter bank market and LIBOR will be steadily pushed up toward the danger zone as discussed before. And in this respect this expanded swap agreement can be either a non-event or a monstrous thing as will be discussed next.

A “Bernanke Plan” to paper over the Euro crises until 2013? A twisted QE3?

As discussed in the previous section, if ECB does not borrow enough Dollar from FED, LIBOR will keep rising and the whole expanded swap agreement will be a non event. However, if ECB borrows enough Dollar to satisfy the needs of European banks, a very strange thing may happen. As we know some Euro region losers, as discussed in Comment 84, have trouble of selling sovereign bonds to refinance the existing bonds and to borrow more to bridge their continuing budget deficits. Suppose Country X, a member of Euro-region, is in such a troubling situation. It is known that Country X, like other troubling members of Euro region, is pressuring its own banks, say Bank XYZ, to purchase its unsold sovereign bonds. Bank XYZ needs to find Euro to purchase those unsold sovereign bonds of Country X. Where the required Euro comes from? One way is to borrow from ECB. So far ECB is refusing to expand its purchase of sovereign debts issued by Euro region countries, meaning that ECB is refusing to perform quantitative easing like FED had done. ECB is unlikely to lend Euro to Bank XYZ to purchase the sovereign debt of Country X, otherwise ECB will be doing a quantitative easing from the back door. What Bank XYZ can do is to enter the Dollar auction of ECB. Bank XYZ probably will use sovereign debt of Country X at hand as the collateral to borrow Dollar from ECB. ECB cannot refuse the sovereign debt of Country X as collateral, since if ECB does refuse, it will be like openly declare that Country X is not credit worthy and will touch off a financial storm, resulting in the actual default of Country X and the disintegration of Euro. Once succeeded in borrowing Dollar, Bank XYZ can sell the Dollar for Euro and purchases the sovereign bonds of its own country. Apparently such a practice will not be limited to one country, but will spread to all Euro-region countries in trouble.

If ECB continues to refuse to conduct quantitative easing and the steadily rising LIBOR needs to be stopped, then the only way is for FED to create as much Dollar as needed to save faltering Euro-region countries as discussed before. In that case one may ask how much Dollar are we talking about. Some estimates that totally 2 trillion euros are needed to save those Euro losers temporarily. Currently Euro Rescue Fund has 600 billion euros. Thus FED may need to shoulder the majority of the remaining 1.4 trillion euros. Before the crash, the balance sheet of FED was about 1 trillion dollars. QE1 had added 1 trillion dollars and QE2 about 600 billion dollars more. We can see that if the expanded swap agreement is used to save Euro losers, the amount of Dollar that FED must create is comparable to QE1 and QE2 combined. In that sense the whole scheme can be considered as a twisted QE3; in a strait forward quantitative easing FED buys U. S. treasuries and equivalent securities, but in the twisted quantitative easing Dollar created by FED will end up buying sovereign debts issued by Euro-region countries.

Conclusion

To avoid a global financial crises originated from Euro sovereign debt disaster temporarily, some one must create a lot of money from thin air to paper over the trouble. Pure talks, without actual money, from the leaders of Euro-region countries will not solve the Euro crises. If it is not ECB, then FED is forced to act and starts the twisted QE3. In the case of the twisted QE3, FED will just hold on to the euros it receives from ECB, but the dollars received by ECB will literally flow into the market. On the other hand if ECB plunges into a quantitative easing, dollars do not need to be created, but a massive amount of euros will flood into the market. FED and ECB may also share the burden for each to go half of the road. No matter how the situation turns out, stock markets are anticipating a lot of money will come into the market to boost stock prices, so the smart money had moved already to take advantage of the coming onslaught of liquidity. However, the stock market is ignoring the possibility that ECB may limit the amount of swap with FED whereas still refuses to do quantitative easing so the Euro crises will intensify. Since there are various possibilities in that regard, we better wait to see how the situation evolves before plunge into the analysis of the outcome.