The Fed as central bank to the world

By Jacqueline Thorpe
Financial Post / National Post, Toronto
Sunday, November 02, 2008

http://www.financialpost.com/news/story.html?id=927271

Nicolas Sarkozy may be pushing for a new financial order but Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson have beaten him to it.

While the French President dreams of global economic cooperation ahead of the G20 summit in Washington, the Fed is quietly becoming central bank to the world, backed by the full might of the U.S. Treasury and a teflon-coated greenback.

Last week saw a new program added to the barrage of bailouts, backstops, and stimuli announced by the United States -- US$30 billion currency swap lines for Brazil, Mexico, South Korea, and Singapore. This is on top of the unlimited supply of greenbacks the United States has provided to the major economies.

The United States will swap wons for greenbacks, allowing South Korean banks to fulfill local demand for U.S. dollars, which had been starved by the freeze-up in the interbank lending markets. Banks can then provide those greenbacks to their local customers to allow them to carry out international business.

In April, South Korea will swap its wons back -- for a fee, of course. David Rosenberg, chief North American economist at Merrill Lynch was quick to pick up on the irony. "The U.S. was supposedly the basket-case nation with the massive deficits whose currency was destined to lose its reserve status and whose credit rating was going to get cut at some point," he said in a note last week. "It is the U.S. that is being called upon to provide unlimited swap lines with Europe one day, and funding for emerging markets the next."

Marc Chandler, chief foreign exchange strategist at Brown Brothers Harriman in New York, said the emerging market swap lines mark a new step in the evolution of the response to the credit crisis.

"It underscores the U.S. leadership role and the Fed's role as defender of the system, which is increasingly broadly conceived," Mr. Chandler said. "This is something that other central banks do not seem prepared to do. Admittedly several Asian countries are talking about pooling reserves and increasing swap lines, but the role of the U.S. and the dollar are different."

The U.S. dollar's status as the main currency of international and central bank business has barely been tarnished by the whole sorry credit crisis. The flight to the perceived safety of U.S. treasuries has been unstinting.

The swap lines give a small "stamp of approval" to each country of their good financial husbandry but also send a message to those left swinging in the wind, Mr. Chandler adds

"Being a friend of the U.S. still matters," he said. "Venezuela, Argentina, and Russia, for example, are unlikely to be thought of as likely candidates for a similar swap program with the Fed. Over time, who is regarded as a friend of the U.S. may impact valuations."

From a sheer tactical perspective, Europeans have missed an opportunity to push the euro as a reserve currency, consumed as they are with their own problems and intent on blaming the United States for the meltdown. Of course Venezuela and Russia have the oil wealth to provide their own bailouts and, to be fair, the United States was not alone last week in swinging into action.

China, Norway, South Korea, Taiwan, and Japan all cut interest rates, and Japan and Germany announced plans for fiscal stimulus. The Bank of England and the European Central Bank are expected to slash interest rates next week.

The actions, combined with a 50-basis-point cut by the Fed, which brings the world's benchmark interest rate to 1%, appear to have finally brought some rationality markets, making one wonder what there will be left for the G20 to do at its summit.

Michael Gregory, senior economist at BMO Capital Markets runs down his credit crisis checklist:

-- Provide near limitless liquidity -- check.

-- Provide capital injections to the financial sector -- check.

-- Provide a way to get rid of soured assets and/or clarity on what they're worth -- check.

-- Give a guarantee on interbank lending -- check.

The focus at the summit then will undoubtedly be on regulation and how to prevent a similar crises, a prospect that amuses Carl Weinberg, chief economist at High Frequency Economics.

"So far we haven't had any doubles," he said. "This time it was the housing market and asset-backed securities. The last time it was equity investment in Asia. The time before that it was loans to Latin America, and the time before that it was S&Ls [the U.S. savings and loan crisis]. Every crisis we've had is a different set of circumstances. The only common element is people tend to get irrationally exuberant about investing in a commodity and when it goes they get nailed."

Many analysts are skeptical of the notion of a global regulator, while Mr. Sarkozy's idea of creating a new global financial system a la Bretton Woods II -- the original had a fixed exchange rate system -- seems pie-in-the-sky.

"The Canadian government is not willing to cede to Washington or Basel or Bombay the right to tell its financial institutions what to do or what it's doing is wrong," said Edwin Truman, a senior fellow at the Peterson Institute for International Economics. "That does not mean one could not have an international understanding on the best way to go about financial business, supervision and regulation. That process is already under way."

The Financial Stability Forum, which brings together representatives from central banks, treasury departments, and regulators around the world was set up after the Asian crisis in 1998 to do precisely that. It has already issued some 67 recommendations on the current crisis on a host of issues from capital requirements to credit rating agencies.

Europe may push for something grander but Mr. Truman is wary. "If they think they're going to use this to gang up on the United States and get the United States to issue mea culpa after mea culpa and turn the supervision of our financial system over to a college of officials from the rest of G20 for the next five years, they have another thing coming," he said.

Until the greenback falters, the United States is firmly in the driver's seat.

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