A Solution to Sudden Stops

• Author: Ricardo Reis
• Position: A. W. Phillips Professor of Economics at the London School of Economics and Political Science
• Pages: 42-43

The IMF and central banks should work together to resolve financial crises

Ricardo Reis

A MAJOR FUNCTIO N of the IMF is to provide short-

term loans to countries that ex perience a sudden

stop in the inflow of private capital. Lef t on their

own in these circumstances, countries c an experi-

ence a sharp depreciation of their excha nge rates,

suffer large reces sions, and likely default on their

foreign debt. Experience shows that thes e events can

quickly spread to other countries. Some insu rance

against sudden stops is va luable, if only to smooth

the outflow of capital over time, prevent “fire sales”

(the sale of assets at prices far below their market

value), and limit contagion. Since the 1944 Bretton

Woods conference, the causes, featu res, and con-

sequences of these sudden stops have changed , but

the IMF’s role as lender of last resort has endured.

Banks al so fall victi m to sudden stops, but of a

different sort. Sudden stops afflict ban ks when they

lose access to the short-term funding they need to

finance their long-term investments. In this situa-

tion, they turn to their centra l bank, an institution

that has long served a s their lender of last resort.

Recently, these two types of sudden stops have

merged. Banks with global operations often borrow in

foreign currencies to invest in assets abroad. In 2007,

when US dollar money markets froze, some banks

outside the United States experienced a sudden stop.

As with country sudden stops, this event involved a

flow of capital across borders, but it was bank, not

sovereign, funding that was at stake. Central banks

were ready to take up their role, but their domestic

currency had to be converted to foreign currency, and

the strains of the financial crisis on foreign exchange

markets made the cost of borrowing skyrocket.

e Federal Reserve provided a solution by open-

ing dollar swap line s with central banks in selecte d

countries. rough these arrangements, the Fed

lent dollars to these central ba nks, which in turn

lent them to their domestic banks to f und their US

dollar investments. Since the sudden stop involved

US dollars, the Fed could provide the needed fu nd-

ing and prevent fire sales of dollar a ssets. As it was

domestic banks that needed funding, it was their

own central bank s—which regulate them and ca n

best assess t heir solvency and the collateral offered—

that provided the funding through their lending

facilities and bore the credit risk . In return, the Fed

held the other countries’ currency, so it bore almost

no risk. If repayment was made, as it always was,

this currency would never enter circulation.

e effectiveness of these centr al bank swap lines

can be asses sed in two complementary ways. First,

central bank lendin g facilities should cap the rates

charged by private lenders and thereby lower the

average market rate. Indeed, t he various US dollar

swap lines signific antly lowered a currency’s basis to

the dollar relative to currencies t hat did not benefit

from a swap line. Second, bank s that have access to

a central bank s wap line should be relatively more

willing to invest in US dollar financial a ssets, since

they can count on the lender of last resor t in the event

of a crisis. e data show that, af ter the rate charged

on US dollar swap lines fell by 50 ba sis points in 2011,

42 FINANCE & DEVELOPMENT | June 2019

A Solution to

Sudden Stops