Sovereign Debt Crisis: A Governor Explains the Fed's Important but Limited Role
Federal Reserve Governor Daniel Tarullo testified on the European sovereign debt problems and related international stabilization effort in front of the House Subcommittee on International Monetary Policy and Trade and the House Committee on Financial Services. What follows are an excerpt from that testimony after Governor Tarullo presented the evolution of the financial turmoil in Europe:
Potential Ramifications for the US Economy
Financial markets in the United States have been buffeted by the European problems. Over the four-week period leading up to May 6, just prior to news that EU members would be meeting to craft the most recent package, broad US stock price indexes declined and implied volatility on equities rose sharply, reflecting some increased aversion to risk. The flight to quality also showed through to US Treasury yields and the foreign exchange value of the dollar, with the 10-year Treasury yield declining 50 basis points over the four-week period and the dollar climbing more than six percent against the euro. Following the announcement of the May 10 package, Treasury yields moved back up slightly and equity prices rebounded, but these moves were subsequently reversed and the dollar rose further against the euro.
These effects on US markets underscore the high degree of integration of the US and European economies and highlight the risks to the United States of renewed financial stresses in Europe. One avenue through which financial turmoil in Europe might affect the US economy is by weakening the asset quality and capital positions of US financial institutions. There are, to be sure, good reasons to believe that these institutions can withstand some fallout from European financial difficulties. In the past year, the Federal Reserve has pressed the largest financial institutions to raise substantial additional capital. Moreover, the direct effect on US banks of losses on exposure to one or more sovereigns in peripheral Europe — which, in the current context of sovereign debt concerns, is generally understood to mean Greece, Portugal, Spain, Ireland, and Italy — would be small. According to the Federal Financial Institutions Examination Council, almost all US exposure to peripheral European sovereigns is held by 10 large US bank holding companies, whose balance sheet exposure of $60 billion represents only 9 percent of their Tier 1 capital. However, if sovereign problems in peripheral Europe were to spill over to cause difficulties more broadly throughout Europe, US banks would face larger losses on their considerable overall credit exposures, as the value of traded assets declined and loan delinquencies mounted. U.S. money market mutual funds and other institutions, which hold a large amount of commercial paper and certificates of deposit issued by European banks, would likely also be affected.
In addition to imposing direct losses on US institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally. Increases in uncertainty and risk aversion could lead to higher funding costs and liquidity shortages for some institutions, and forced asset sales and reductions in collateral values that could, in turn, engender further market turmoil. In these conditions, US banks and other institutions might be forced to pull back on their lending, as they did during the period of severe financial market dysfunction that followed the bankruptcy of Lehman Brothers. The timing of such an event in the current instance would be unfortunate, as banks generally have only recently ceased tightening lending standards, and have yet to unwind from the considerable tightening that has occurred over the past two years. Moreover, aggregate bank lending, particularly to businesses, continues to contract. The result would be another source of risk to the US recovery in an environment of still-fragile balance sheets and considerable slack. Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests that it is not out of the question.
Another means by which an intensification of financial turmoil in Europe could affect US growth is by reducing trade. Collectively, Europe represents one of our most important trading partners and accounts for about one-quarter of US merchandise exports. Accordingly, a moderate economic slowdown across Europe would cause U.S. export growth to fall, weighing on US economic performance by a discernible, but modest extent. However, a deeper contraction in Europe associated with sharp financial dislocations would have the potential to stall the recovery of the entire global economy, and this scenario would have far more serious consequences for US trade and economic growth. A resultant slowdown in the United States and abroad would likely also feed back into the health of US financial institutions.
Federal Reserve Responses to the Crisis
Notwithstanding the fact that European sovereign debt problems could have negative consequences for US and global economic growth, successful resolution of these problems ultimately rests predominantly on effective European policy actions. The Federal Reserve has only a limited, though important, role to play by helping to prevent liquidity pressures from intensifying and leading to a more widespread freezing up of financial markets, including in the United States. To counter growing strains in dollar funding markets in Europe, last week the Federal Reserve re-established dollar liquidity swap lines with a number of foreign central banks following the receipt of information on the large support package developed by European leaders.
The liquidity lines, which were authorized by a unanimous vote of the Federal Open Market Committee, are structured similarly to those that were put in place during the financial crisis. As you know, central bank swap transactions have a long and well-established history, and their use by the Federal Reserve and other central banks goes back to the Bretton Woods era of fixed exchange rates. In their current vintage, they are used by foreign central banks to relieve or forestall temporary liquidity pressures in their local dollar funding markets. Foreign central banks draw on these lines by selling foreign currency to the Federal Reserve in exchange for dollars. The foreign central banks then lend these dollars to financial institutions in their jurisdictions. At maturity, the foreign central bank returns the dollars back to the Federal Reserve in exchange for its own currency at the same exchange rate that prevailed at the time of the initial draw, and pays interest as well.
The loans provided by the foreign central banks to institutions abroad are offered at rates that would be above market rates in normal times. As such, when market conditions are not greatly strained, demand for dollar liquidity through the swap lines should not be high, as market alternatives would be more attractive. Likely for that reason, the dollar liquidity offerings by foreign central banks to date have elicited only a modest demand. However, even in such instances, the existence of these facilities can reassure market participants that funds will be available in case of need, and thus help forestall hoarding of liquidity, a feature that exacerbated stresses during the global financial crisis.
Even if usage increases significantly, the risks to the Federal Reserve, and by implication the risks to the US taxpayer, are minimal. US interests are safeguarded by the foreign currency held by the Federal Reserve during the term of the swap. Moreover, our exposures are not to the institutions in the foreign countries ultimately receiving the dollar liquidity but to the foreign central banks. Over the life of the previous temporary swap program (from December 2007 to February 2010), all swaps were repaid in full, and the Federal Reserve earned $5.8 billion in interest. Finally, the Federal Reserve bears no market pricing risk in these drawings, since the swaps are designed so that fluctuations in exchange rates or interest rates have no effect on the payments made at the end of the transaction.
Conclusion
The agreement of the Federal Reserve to reinstate foreign exchange swap arrangements was designed not to insulate banks and investors from losses they may incur, but as a prudent effort to help minimize the risk of financial turmoil in Europe, with the consequences that would ensue for the global financial system, including the United States. In the worst case, such turmoil could lead to a replay of the freezing up of financial markets that we witnessed in 2008. With unemployment remaining quite high, and with continued need for balance sheet repair by many businesses, financial institutions, and households, it is particularly important that the United States not sustain a significant external shock.
The policy measures announced by European authorities a week and a half ago elicited a quick, strongly favorable market reaction, holding out hope that further financial disruptions can be averted. However, as reflected in the negative turn of equity markets later in the week, and continued tight funding in some European markets, uncertainties are still clouding financial markets. Market participants continue to seek clarification of the terms and scope of the measures broadly outlined by the relevant European countries and institutions.
In Europe, a key near-term priority is to continue work to prevent a drying up of liquidity by providing both euro-denominated and, through the dollar liquidity swaps, dollar-denominated credit to financial institutions. But, even if effectively implemented, this support, along with the support for sovereign debt markets provided by the other components of the EU package, will not solve the sovereign debt problems; it will only provide time to make necessary policy adjustments. Lasting beneficial effects will require credible action to bring fiscal deficits under control. For the EU as a whole, it seems clear that the mechanisms of the European Economic and Monetary Union need further development if it is to achieve its intended aims. Last week, the European Commission issued a communiqué outlining plans to enhance surveillance and develop a crisis management framework. I would anticipate a robust debate over these and related matters in the coming months.
The United States is in a very different position from that of the European countries whose debt instruments have been under such pressure. But their experience is another reminder, if one were needed, that every country with sustained budget deficits and rising debt--including the United States--needs to act in a timely manner to put in place a credible program for sustainable fiscal policies.
Go to the Federal Reserve site for the complete testimony.