Sovereign Wealth Fund Institute

This graph plots a change in the growth of the balance sheet of the Federal Reserve versus the People’s Bank of China (PBOC) in a percentage of local gross domestic product (GDP). In recent years, China has expressed serious concern about the unprecedented growth of the Federal Reserve’s balance sheet and how it can impact the value of China’s over three trillion in foreign currency reserves. It is common knowledge that Chinese trade surpluses generates major flows of dollars back to China. The PBOC purchases foreign exchange entering China. These purchases are financed with the issuance of bills denominated in renminbi.[Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

Source: People’s Bank of China, Federal Reserve, BEA, National Bureau of Statistics, China

According to the press release, “The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.

These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013. In addition, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank will continue to offer three-month tenders until further notice.

As a contingency measure, these central banks have also agreed to establish temporary bilateral liquidity swap arrangements so that liquidity can be provided in each jurisdiction in any of their currencies should market conditions so warrant. At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar, but the central banks judge it prudent to make the necessary arrangements so that liquidity support operations could be put into place quickly should the need arise. These swap lines are authorized through February 1, 2013.

Federal Reserve Actions
The Federal Open Market Committee has authorized an extension of the existing temporary U.S. dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank through February 1, 2013. The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.

U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.”

Source: Federal Reserve

Western central banks and monetary authorities have less wiggle room in the current environment. In 2008, the global financial system was operating under terrible economic conditions with numerous financial institutions failing. At that time, the United States was fortunate to have the flexibility to act in terms of using the Federal Reserve, authorizing TARP, and relying on outside capital coming from sovereign funds. Now, the opposite is occurring as economic conditions have gradually improved since 2008; however, fiscal deficits are plaguing governments across Europe and in the United States. [Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view site content.]

The Dodd-Frank Wall Street Reform and Consumer Protection Act is now a U.S. federal statute and signed into law by U.S. President Barack Obama.  Now that the law is in place, U.S. agencies such as the Commodities Futures Trading Commission (CFTC) and the Federal Reserve Board are drafting proposals under newly minted regulatory powers, especially in the area of swap margin requirements and classifying swap participants.  Counterparty risk cannot be understated and it furthered the slogan “too big to fail”.  The agencies are proposing to include sovereign funds as “financial end users” or “financial entities”.  If this proposal passes, this will increase their margin requirements, essentially mandating sovereign wealth funds to pledge their assets to back American financial institutions.   This brings further issues to light, since some sovereign funds may need legislative or committee action to enlarge the amount of pledged assets to meet margin calls.  There is also political risk that foreign governments might counteract by providing similar legislation against the U.S. government.

Under the proposal, they state:

“The Commission notes that these types of sovereign counterparties do not fit easily into the proposed rule’s categories of financial and nonfinancial entities. In comparing the characteristics of sovereign counterparties with those of financial and nonfinancial entities, the Commission preliminarily believes that the financial condition of a sovereign will tend to be closely linked with the financial condition of its domestic banking system, through common effects of the business cycle on both government finances and bank losses, as well as through the safety net that many sovereigns provide to banks.

Such a tight link with the health of its domestic banking system, and by extension with the broader global financial system, makes a sovereign counterparty similar to a financial entity both in the nature of the systemic risk and the risk to the safety and soundness of the covered swap entity. As a result, the Commission preliminarily believes that sovereign counterparties should be treated as financial entities for purposes of the proposed rule’s margin requirements.”

Source: U.S. Commodities Futures Trading Commission

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