A. Introduction

1. Maintaining the stability of FX funding is one of the key elements ensuring the financial stability of the system. For globally active banks with multinational operations, FX funding is an integral part of their overseas operations. In emerging market economies (EM), FX funding often reflects capital inflows (into banks, nonfinancial corporations, and sovereign), a reversal of which is a major source of systemic risk not only to the financial sector, but also to the whole economy. Moreover, risks to FX funding in EM are often associated with broader shocks to the balance of payment (BOP), including large exchange rate depreciation and declines in key commodity export prices. The global financial crisis demonstrated that shocks to FX funding give distinctive challenges to banks, different from domestic liquidity problems.

2. In response to systemic FX liquidity shortage during the global financial crisis, many central banks and governments provided FX liquidity. In advanced economies (AE), central banks introduced temporary FX emergency liquidity facilities for banks. The supply of dollar was often backed up by time-bound swap arrangement with the U.S. Federal Reserve Board (FRB). In EM, a wider range of measures were taken, including those very similar to FX market intervention, changes with capital account restrictions, and targeted support for non-financial corporates. Many countries drew down their international reserves, while some established bilateral swap arrangements with central banks issuing hard currencies and/or sought IMF programs.

3. What are the benefit and costs of introducing FX liquidity facility? There are questions about the need for introducing such facility when the CBR already has committed domestic liquidity support and ample FX was supplied in spot FX market under exchange rate peg framework. In the 2008 crisis, banks and corporates managed to obtain FX by first securing domestic liquidity and then converting them to FX in spot market

4. This chapter explores the rationale for introducing such FX facility. For one, the CBR is moving to inflation targeting framework from exchange rate peg. This will limit the scope of large scale FX intervention in the future. Moreover, the policy mix have, in effect, provided dollar funding at negative rate, making it profitable to borrow in Ruble, convert them into dollar with forward cover and then invest in dollar assets. During the global financial crisis, this appears to have worsened already high balance of payment outflow pressures, risking a BOP/currency crisis. In the end, the CBR devalued the Ruble and tightened monetary policy to avoid a full-blown crisis and regain confidence. On the contrary, directly lending in FX would give the CBR more flexibility to set the adequate levels of dollar interest rate, limiting potential misuse. Providing FX liquidity out of international reserve is also consistent with the need for tightening domestic monetary conditions, which often becomes relevant for EM under BOP crisis pressures.

5. If the CBR introduces FX liquidity facility, care should be taken to establish a framework that can minimize misuse. Proper risk management and monitoring should be in place to prevent excess buildup of FX liquidity risks to begin with. Additional reporting might become necessary to identify institutions that are truly in need of liquidity assistance. It should be emphasized that it is an exceptional measure to counteract against a systemic stress and not a facility to be used for regular operations, let alone expansions.

B. Primer: FX Funding Instruments

6. Banks can rely on a number of FX funding options.

• Local funding abroad: If a bank has branches and subsidiaries abroad, they may tap into retail deposits in the host countries. Wholesale funding in the host country is another option, including issuing commercial paper, CDs, long-term bonds (purchased by local mutual funds and other institutional investors). If the bank has qualified assets to be pledged as collateral (such as local government bond and other securities), they could use repurchase agreement (repos) or other secured funding options, which are relatively more stable and cheap compared to unsecured funding, especially during stress time. Some banks may have status as a counterpart of local central bank’s monetary operations, which allows them to tap local liquidity facilities.

• Cross-border and cross-currency funding: A bank can issue international bonds in foreign currency. If a bank has foreign parent, the parent bank might send FX liquidity to the subsidiary/branch. Another avenue is cross-currency funding where banks first obtain domestic currency funding and then convert them into foreign currency by exchanging them in spot FX market while hedging currency risk with FX forward (shorter-term) or currency basis swap (longer-term).² Cross-currency funding allows banks to access FX funding even when they do not have access to direct FX funding instruments or their interest rates are too expensive.

• FX funding in domestic market: In some dollarized economies in particular, banks may collect FX deposits in their home country.

C. FX Liquidity Shortage and Support since the Global Financial Crisis

7. The global financial crisis caused systemic FX liquidity shortages in funding and FX markets around the world.

• In advanced economies (AE), the distress in money markets destabilized wholesale bank funding (in both domestic and foreign currencies), which had been extensively used to expand banks’ investment in securities and derivatives (Adrian and Shin, 2010, and IMF’s Global Financial Stability Report, 2010). Banks often relied on local wholesale funding, as they lacked deposit base in FX. Notably, some European banks built up large exposures to U.S. mortgage securities, financed with wholesale funding from U.S. money market mutual funds (Baba, McCauley, and Ramswamy, 2009). They came under serious liquidity distress when the money market mutual funds cut down financing due in part to their own withdrawal pressures and to increased counterparty risk³ with European banks.

• The systemic liquidity shortages disturbed normal functioning of FX swap and cross-currency basis swap markets, making cross-currency funding extremely expensive or weakening its availability (see Box 1 for details). The market liquidity dry up limited arbitrage trading in FX derivatives markets, violating covered interest parity condition for a prolonged period since the crisis even for euro, yen and dollar (Figure 1). This gap raised the cost of cross-currency dollar funding using euro and yen above dollar Libor rate.

• In emerging market economies (EM), FX liquidity shortage was closely related to BOP flow reversals, and therefore, its impact was felt by the broad segments of the economy beyond the financial sector. Capital flows to EM swing substantially when global investors’ risk aversion changes. Fluctuation in commodity prices can affect both current and capital account flows for a commodity producer such as Russia. All of these lead to drastic surge in exchange rate volatility. Governments may carry high levels of foreign currency debt. Banks may be exposed to FX and FX liquidity risks⁴, including though lending to unhedged borrowers. Non-financial corporations and household may also have large FX mismatches between their assets and liabilities (e.g., dollarized economies). These economy-wide vulnerability to FX and FX liquidity shocks can result in solvency problems (for sovereigns, banks, and corporate) and require macro-policy adjustments, in addition to financial sector policies.

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Global Turbulences in FX Forward Markets and Cross Currency Dollar Funding Cost

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

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Box 1.

Mechanics of Basic Cross-Currency Funding Using FX Forward and Currency Basis Swaps, and their Behavior during a Systemic Crisis

For banks that need FX (dollar) funding, there are two basic options: [A] direct funding in dollar interbank market (such as Libor) and [B] cross-currency funding using FX forward or currency basis swaps (Figure 1.1). Dollar interest rate with option [A] is i_usd, which is set at the time of contract (t=0). Dollar interest rate with option [B] is i_usd_cc, which is determined by spot Ruble-dollar rate, forward Ruble-dollar rate with one month tenor, and interest rate in Ruble interbank loan market. All of these three inputs are known at the time of contract (t=0), therefore i_usd_cc is set with certainty at t=0.

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Mechanics of Cross-currency Funding

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

Notes: S(t=0) is Ruble-USD exchange rate (1 dollar for S Ruble) as of t=0; F(t=0) is Ruble-dollar forward exchange rate with 1 month tenor; i_usd(t=0) is interest rate in dollar Libor market as of t=0; i_rub(t=0) is interest rate in Ruble interbank market as of t=0; and i_usd_cc(t=0) is cross-currency dollar interest rate using transactions [B], using Ruble-dollar spot and forward markets and Ruble interbank market.

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During normal time, healthy arbitrage transactions should bring the difference between the two interest rates close to zero (net of transaction costs) especially for well-developed and liquid FX markets for advanced economies—this is the nature of covered interest parity (CIP). When direct dollar interest rate is higher than cross-currency dollar rate, an arbitrager can make money (with certainty) by borrowing in Ruble, convert it in spot market into dollar, and then cover its future dollar value by selling dollar in forward market and then invest in dollar Libor market.

At the time of systemic crisis, however, the increased recognition of counterparty risk often obstruct these arbitrage transactions, violating CIP (Figure 1). Banks become increasingly wary about their counterparty becoming distressed in the future (i.e., credit risks of the countrerpary), refraining from being engaged in arbitrage transactions despite of (FX risk free) profit-taking opportunities. Some may lose access to some or all of the four key markets required to take the arbitrage positions or face much more expensive price than what the reported price indicate. These are the transaction-level mechanics leading to market liquidity “dry up” in the FX forward and currency basis swaps markets. Such violation of CIP was widely observed for a large number of currency markets (Baba and Packer, 2009a). Indeed, the violation of CIP (and some other arbitrage-free conditions) can be used as an indicator of systemic liquidity shortage (IMF, Global Financial Stability Report, 2011a).

For euro and yen, the CIP has continued to be violated since the Lehman crisis well into 2013 (Figure 1). The acute systemic liquidity shortage that followed the Lehman collapse resulted in the large jumps of both dollar Libor rate, euro-dollar and yen-dollar cross currency rates, and their differences. The rates have come down rapidly, as major central banks expanded liquidity support in domestic currency and, in some cases, in dollar (IMF, 2010). However, possibly due to the sustained concerns over counterparty risks, the CIP hasn’t been fully recovered for several years, widening more when global markets experienced renewed pressures (e.g., end 2011 when the concerns over European debt crisis deepened).

8. There are central banks that have FX liquidity facilities, some on temporary basis in response to the crisis. The IMF surveyed central banks about their monetary policy instruments in 2008 and 2010 (Gray and Jadrijevic, 2010).⁵ As of 2010, 67 (32) percent of central banks conduct spot FX (FX swaps) transactions as part of open market operations. Central banks in Middle East were the most involved in spot FX transactions (85 percent). Some central banks—Bahrain, the Czech Republic, and the European Central Bank (ECB)—explicitly reported that they used FX swaps only on a temporary basis.

9. In AE, central banks introduced temporary FX liquidity facilities to banks, often using similar framework to domestic liquidity facilities and backed up by swap agreement with the FRB. Key features of these facilities are follows.

• Temporary: In key AE⁶, FX facilities were introduced at end 2007, most of which expired in February 2010. The ECB, United Kingdom, Switzerland, Canada, and Japan reinstituted the facilities in May 2010 when market pressures reemerged, but these are expected to expire in 2014.⁷

• Emergency: The facilities were offered against systemic crises and not standing facilities that bank can count on normal times.⁸

• Counterparty: The facilities were offered to financial institutions that satisfy similar eligibility criteria to domestic liquidity support.

• Operations: Some offered (reverse) repo (including the Bank of England, the ECB, and the Swiss National Bank), and the others offered FX swaps (the Bank of Japan, BOJ). Some central banks offered limited quantity based on competitive auctions, while some offered the facility without quantitative ceiling, using fixed rate, noncompetitive auction where all bids would be filled (full allotment, Table 1).

• Collateral: The facilities were collateralized, using similar eligible collaterals to domestic liquidity facilities in case of repo (with haircuts) or using domestic currency cash as collateral in case of FX swaps.

• Backup: Most AE central banks that offered FX facilities established dollar swap arrangement with the FRB.

• Pricing: The costs of these funding were set at levels that are expensive during calmer times but competitive during stress periods (Figure 2).The rate (OIS+100 bps initially and the +50 bps since end 2011) has been above dollar Libor and cross-currency dollar rate most of the time, but the rise in market rate, especially cross-currency dollar rate at end 2011 made central bank funding more attractive.

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Cost of AE Central Bank Dollar Facility

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

Sources: Bloomberg and Staff calculations.1/ Cross-currency funding rate is synthetic USD funding costs by borrowing in yen/euro at ye Libor/euribor rate and converting into U.S. dollar in spot market with FX forward cover.2/ USD lending facility by BoJ and ECB charged OIS+ 100 bps up to mid December 2011 and then cut to + 50 bps.

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10. EM, on the other hand, used a wider range of tools to ease dollar funding conditions. As summarized in Table 2, the measures included those very similar to spot FX market intervention⁹; changes with capital account restrictions; changes in FX reserve requirements; open market operations including FX swaps and other types of lending in FX to banks; regulatory forbearance and amendment; and targeted support for non-financial corporates¹⁰. Many countries drew down their international reserves; some established bilateral swap arrangements with the FRB or other central banks; and some asked for IMF-supported programs. Some of these measures were directly or indirectly meant to provide FX liquidity for corporates in addition to banks, as FX and FX liquidity risks were often widespread among non-financial corporations reflecting the openness of the economy.

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11. As in AE, EM central banks also offered domestic monetary easing and liquidity support, although they were initiated at a later stage in the global financial crisis. The global financial crisis started in AE, and many EM faced the downturn only in late 2008. In earlier part of the year, EM economic growth was generally strong with persistent inflationary pressures, which warranted tight monetary policy stance. They turned to monetary accommodation only when the global financial stress intensified upon the Lehman’s failure. As capital flow reversed and economic outlook deteriorated, central banks took measures to mitigate the broad liquidity shortage and balance sheet effects.

12. However, not every EM could aggressively ease domestic liquidity conditions. For those with their own vulnerability, the external shock evolved into a full-blown BOP crisis, and they needed to raise domestic policy rate in order to regain confidence and limit capital outflows. In general, EM could face more serious trade-offs between giving support for balance sheet misalignment of the private sector and maintaining the overall confidence in the economy. Unlike AE which issue international reserve currencies, monetary loosening and unconventional monetary policy in EM at the time of financial distress could fuel capital outflows and sales pressures on their currency, increasing the chances of currency crisis (Jacome, Sedik, and Townsend, 2011). However, even in such cases, a central bank might still be able to offer limited FX facilities, to the extent its international reserves allow, as they are consistent with monetary tightening (i.e., the reduction of net foreign assets and reserve money). Indeed, Hungary offered FX swaps to mitigate FX liquidity needs (Table 2, and IMF, 2009).

D. Russia’s “FX Liquidity Support” during the Crisis: Benefits and Consequences

13. Turning to Russia, the CBR provided FX liquidity in spot market through 2008-09, but this was within its exchange rate peg framework rather than directly providing FX loans (Figure 3).¹¹ Russian financial system experienced serious generalized liquidity shortage, as oil prices declined and external borrowing by banks and corporates reversed. The CBR provided ample domestic liquidity to banks and corporates (channeled through banks) including with uncollateralized lending to banks.¹² The CBR did not offer FX loans per se. However, it supplied substantial FX out of international reserves in spot exchange rate market in order to maintain Ruble at its target range.¹³ Banks and corporates obtained FX by first securing domestic liquidity and then convert them to FX in spot market.

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External and Monetary Conditions in Russia during the 2008–09 Crisis

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

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14. However, Russia risked a BOP/currency crisis.¹⁴ The accommodative monetary policy providing large domestic liquidity at low interest rate immediately after the Lehman shock fueled further capital outflows. At macroeconomic levels, the sudden change in exchange rate expectations trigged by the collapse in oil prices led banks and corporates to seek to hedge their foreign currency exposures, exacerbating pressure on the Ruble. The CBR’s FX intervention reduced international reserves from a peak of $598 billion in August 2008 to a trough of $375 billion in March 2009 (Figure 3). Confronted with surging reserve losses, the Ruble was devalued sharply, and monetary policy tightened with higher interest rate and withdrawal of domestic liquidity support to banks (Figure 4).

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Russia’s Interest Rate Policy: 2008–10

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

Sources: CBR

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15. Pricing appears to have been a key problem with the policy mix in 2008-09. The best practices for liquidity support during a systemic crisis (Box 2) suggest that it is critical to provide liquidity at rates that do not give substantial arbitrage profits to banks. The pricing problem with the CBR framework comes out clearly when the costs are compared with those for AE facilities.

• In advanced economies: The charges on the FX facilities provided by key AE central banks were broadly consistent with market conditions: the dollar interest rates charged by the ECB and BOJ (OIS +100 bps initially and then +50 bps since end 2011) were more expensive than dollar Libor and cross-currency funding rate most of the time but were less expensive during stress period (e.g., end 2011, Figure 2, Box 1).

• Arbitrage opportunity in Russia: In contrast, interest rate structures for Russian banks in late 2008 were such that banks could earn substantial risk-free arbitrage gains by borrowing in Ruble and investing in dollar. The implied dollar funding rate using dollar-Ruble forward fell to negative upon the Lehman event (Figure 5)¹⁵. Banks who maintained access to these rates¹⁶ could earn FX risk-free profit by borrowing in Ruble (at interbank MosPrime or CBR repo rates) and lending in dollar (Libor or other) markets. The interest earning from dollar was near zero after the FRB cut its policy rate, and MosPrime (1 month), by comparison, was high at over 20 percent levels. Nonetheless, the main source of profit was the Ruble depreciation implied in dollar-Ruble forward market, amounting to annualized 30-50 percent in late 2008.

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Cross-Currency Arbitrage Opportunities in Russia and Capital Flows: 2008–09

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

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16. The pricing problem appears to have further fueled already severe capital outflow pressures. The capital flows turned to large net outflows in 2008Q4. Especially, the acquisition of foreign assets—consistent with the arbitrage trading—contributed to this turnaround more than the reduction in liabilities (Figure 5). Indeed, Ishi, Stone, and Yehoue (2009) reference news reports discussing that some Russian banks used the cheap Ruble liquidity to invest in abroad and profit from depreciation.

17. Directly providing FX loans/swaps instead can, in principle, mitigate some of the above issues. A central bank can set the right FX borrowing costs that do not create arbitrage opportunities, instead of indirectly relying on (out-of-parity) market FX forward rates. If fixed amount of FX is auctioned off at competitive prices, it would help delivering the scarce FX liquidity to those who need them the most. If FX loan is provided out of international reserves (instead of providing domestic currency liquidity and then ask banks to convert them into FX), net foreign assets decline and domestic monetary conditions are tightened. But such tightening might be desirable when the central bank needs to raise domestic interest rate in order to regain confidence and limit the possibility of a currency crisis.

18. Lastly, having the capacity to provide FX liquidity can become more important when Russia fully moves to inflation targeting framework. The CBR is aiming at moving to inflationtarget framework in 2014, under which intervention in FX market becomes harder to justify. Using auction and intervening based on rules could give different wrap from FX intervention to maintain exchange rate, in reality. However, it is hard to draw a clear line between FX provision and intervention in reality as seen in the case of Mexico. Furthermore, Ishi, Stone and Yehoue (2009) showed that countries with inflation targeting framework were more likely to introduce FX liquidity facilities during the last crisis.

E. Key Considerations for Establishing Effective FX Liquidity Safeguard in Russia

19. An effective FX facility should follow principles similar to liquidity support in general (Box 2). Without adequate safeguards, central bank facilities could cause moral hazard and eventually cost losses to the central bank. Moreover, the adequacy and effectiveness of liquidity provision framework needs to be judged in the context of overall crisis prevention and management framework, which includes framework for supervisory early intervention of problem banks (crisis prevention), micro- and macro-prudential supervision and tools, and crisis management tools (official liquidity and capital support, orderly and effective resolution, and deposit guarantee schemes). Recommendations in 2011 FSAP should guide the issues for further improvement in this broad area.¹⁷ Nonetheless, there are a few specific areas that should be strengthened when considering FX liquidity facilities in Russia.

20. First and foremost, it is important to monitor and limit the buildup of vulnerability. The financial crisis in Russia in 2008-09 was partly triggered by global development but its root causes were domestic. Domestic bank credit to the corporate and household sectors rose at an unsustainable level of approximately 400 percent over the four years prior to the crisis. Fueled by rising property and commodity prices and the authorities’ earlier focus on exchange-rate stability, Russian bank lending was increasingly financed by external borrowing (Figure 3, 6). Thus, banks and corporates were in vulnerable to sudden changes in exchange rate expectations.

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Russia Banks, Foreign Financing and Credit Growth

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

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21. In particular, terms and uses of external debt for both banks and corporates need to be monitored carefully. Non-bank private corporations rely more on external debt than banks, and borrowing has been picking up strongly once again recently (Figure 7). Bank external debt is rising again as well, but their net foreign assets have turned to positive since 2009, which is a distinctive improvement compared to the time just before the global financial crisis. When assessing FX maturity mismatch/liquidity risks, it is necessary to look beyond contractual maturity. External borrowings often include covenants that give creditors options to request repayment before maturity when certain market conditions are met¹⁸ Many of the external borrowing by Russia contracted before the global financial crisis indeed had such covenants, which suddenly shortened residual maturity and increased liquidity need exactly when the market conditions deteriorated.

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Russia’s External Debt: 2005–13

Citation: IMF Staff Country Reports 2013, 311; 10.5089/9781484343470.002.A003

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22. For fuller assessment of cross-border risks that often contribute to FX liquidity risks, home host collaboration, and regular data collection are particularly relevant.

• As pointed out by 2011 FSAP, the CBR monitors a rather limited set of banks’ cross-border activities. Cross-border exposure data by country are limited to inter-bank claims. While balance of payment data provide some information about cross-border financial flows for banks, they do not cover funding and investment activities of Russian banks that do not cross the Russian border.¹⁹ If, for example, Russian banks build similar positions to European banks’ exposures in the United States (obtain funding from money market funds in the United States to purchase U.S. securities in U.S. markets), it will be hard to gauge the exact extent of such exposures with existing data.

• More broadly, reporting and monitoring of cross-border exposures, liquidity, and FX liquidity is weak in most countries, including AE, even though data on overall liquidity are being enhanced, as countries prepare for introducing Basel III liquidity regulations.²⁰ Still, the regulatory requirements to cover FX liquidity risks are scant. When needed, some national supervisors require systemically important institutions to report additional details in line with the risks and vulnerability the financial systems face.

23. Stress test, especially bottom-up stress tests could be effectively used to monitor FX and FX liquidity risks even when there is limited regulatory reporting. Bottom up stress tests are organized by supervisor and implemented by banks. The supervisor usually sets up specific common scenarios and shock assumptions to be applied to all the participating banks, and banks calculate the impact using their own internal data. Due to limited liquidity data, many supervisors rely more on banks’ data and methodology for liquidity stress tests than solvency tests (Schumacher and Oura, 2012). The IMF survey on stress testing by supervisors/central banks (Oura, 2012) indicates that about a half of the regulators conducts separate FX liquidity stress tests. For the Japan 2012 FSAP²¹, the IMF and the BOJ focused on U.S. dollar liquidity risks in their liquidity stress test, including the roll-over risks with FX swaps (one of the key dollar funding tools for Japanese banks), which materialized after the Lehman failure.

24. It will be extremely important to make it clear that a possible FX facility is an exceptional measure against a systemic crisis and not standing facility. Such exceptional liquidity facilities (both in domestic or foreign currencies) should not be misused to finance banks’ regular operation or let alone credit expansion. Setting expiration date explicitly and charge costs in line with market conditions are essential for avoiding moral hazard and misuse, which can not only cause some direct loss to the central bank but also risk large capital outflows and currency crisis.

25. Any liquidity facility should be consistent with broad policy packages for regaining confidence. For EM, unconventional monetary policy and other financial sector support upon crisis, can do more harm than good when a country has its own domestic vulnerability. The central bank and government might need to make difficult choices under substantial uncertainty. At the height of a crisis, one needs to focus on measures that can help regaining confidence. For instance, Stone, Walker and Yasui (2009) discussed various FX liquidity support taken by Brazil in 2008–09, and point out that the announcement of the swap arrangement with the U.S. FRB contributed the most among other FX support measures (including spot and futures market intervention, FX swaps auctions, dollar lending to exporters and corporations with external debt) in stabilizing the FX markets.