Currency Swaps: Fed=>Brazilian Central Bank=>Real Sector

Last week, the IMF held a discussion entitled "From Lombard Street to Avenida Pauista: Foreign Exchange Liquidity Easing in Brazil in Response to the Global Shock of 2008-09". The presentation highlighted the Brazilian Central Bank’s FX swap agreements with the Fed in the aftermath of the Lehman Brothers collapse.

These swaps had several unusual features.

First, central banks typically control the provision of domestic liquidity, not foreign exchange. By arranging currency swaps with the Federal Reserve, the Brazilian Central Bank (BCB) was able to serve as a critical source of dollar funding.

Second, traditional central bank FX interventions aim to influence the exchange rate via the spot market. In this particular case, the BCB circumvented the FX market, aiming to influence liquidity rather than the exchange rate.

Third, the BCB explicitly addressed FX liquidity problems in the real sector, targeting non-financial corporations rather than banks. This is a very unusual move, as central banks do not typically provide direct liquidity to the real sector.  

Why was the BCB forced to adopt such measures?

In the lead-up to the fall of 2008, many Brazilian corporations had taken short dollar positions via long-term dollar loans. This strategy was driven by lower dollar borrowing costs and a long-term trend of real strengthening (something we saw in most emerging markets):

When Lehman Brothers collapsed, FX markets froze and the real weakened precipitously, posing a serious threat to the solvency of Brazil's corporate sector. Most corporations needed dollars to meet their short-term liquidity obligations, yet many Brazilian firms were unable to roll over their dollar debts, at any price (non first-tier firms were completely shut off to dollar markets). To make matters worse, one half of Brazil’s exports were funded through trade credits, and these lines were completely closed.

In response, the BCB did 5 things:

1. Spot market intervention of $8bn (out of total reserves of $200bn);

2. Net sales of $34bn in dollar futures, in order to help corporations get out of long future real positions;

3. Dollar lending against dollar collateral at auction for anything rated A or higher ($13bn);

4. Non-trade based dollar loans ($2bn); and,

5. FX swap auctions: spot dollar sales with forward dollar repurchase ($12bn)

How did these FX swaps work?

Essentially, when the BCB sells an FX swap, the real strengthens in the spot market and weakens in the forward market, reducing the implied dollar exchange rate. 

The selling of the FX swap has a similar impact to an outright dollar loan, allowing a Brazilian counter-party to convert local currency liquidity to dollar liquidity.

How effective were these efforts? 

The market responded positively to the mere announcement of the emergency swap provisions, bringing down basis spreads by 200 points and reducing overall volatility. The BCB's actual actions elicited less of a market response.

Thus, announcements can be more effective than actions themselves, if the announcers are considered credible. 

Ironically, much of the BCB's credibility stemmed from the fact that it had adequate FX reserves. Hence, due to its abundant supply of dollars and currency swap options with the Fed, the BCB was able to provide the necessary FX liquidity to its real sector without having to dip very deep into its own stock of reserves. 

As I have noted before, amassing large stockpiles of foreign currency reserves will continue to be the order of the day in the post-crisis world.