The SEC builds a safety net for the global dollar system. Will Trump dismantle it?

Author: Vincent Arnold

Federal Reserve Chairman Jerome Powell reiterated last month that the Fed is willing and able to extend currency swap agreements to other central banks “when necessary.”

Recently, foreign officials have increasingly worried that the Federal Reserve might refuse to extend central bank currency swap agreements during a crisis. Although the Federal Reserve has not changed its long-term policy, given that the Trump administration is willing to adopt unconventional measures to achieve its economic goals, European countries (and their banks) are taking this possibility seriously. However, undermining the reliability of the global dollar safety net would be a policy that harms both others and oneself.

The currency swap agreement is an arrangement reached between the Federal Reserve and other central banks, aimed at providing support during periods of dollar liquidity shortages. This type of financial stability tool has a history of several decades and was widely used during the 2008-09 financial crisis. The global dollar liquidity provided by the Federal Reserve is a public good, but the United States can also benefit from it; the overseas dollar markets provide credit to American households and businesses, and the collapse of these markets would trigger contagion effects for the U.S.

Although the Federal Reserve and other central banks describe them as neutral financial instruments, scholars, including myself, believe that these agreements have implicit political attributes, as they can align with national security and economic interests. The Trump administration may attempt to view them purely as geopolitical tools.

However, withdrawing from the offshore dollar market will run counter to its core trade and economic goals. The Federal Reserve’s swap agreements serve as a safety valve, alleviating the pressure of accumulating dollar assets overseas—this pressure is precisely at odds with the macroeconomic goals proclaimed by the government. The U.S. trade deficit (i.e., current account deficit) requires foreign capital inflows (i.e., capital account surplus) to finance it. Reducing the trade deficit is clearly a priority for the Trump administration, which is implementing interventions on the current account side, such as tariffs.

Many analysts believe that capital account intervention is also on the agenda. Important government advisors, such as Stephen Miran, the chairman of the Council of Economic Advisers, have discussed this possibility (although Miran later clarified that this idea is not current policy), and former U.S. Trade Representative Robert Lighthizer has also considered similar ideas. The logic behind such proposals is that reducing financing channels for the U.S. deficit is one of the ways to reduce the deficit itself.

Although such causal inferences are open to debate, there is strong academic evidence supporting the view that the accumulation of dollar assets by foreign entities has fueled the U.S. trade deficit. Swap agreements may reduce the demand for foreign governments and central banks to hold dollar reserves, as they provide an alternative mechanism for dollar insurance.

Asian economies deeply realized this during the 1997 financial crisis. Economic commentator Martin Wolf recently pointed out that at that time, Asian countries could not print money to save themselves during a bank run, and “the conclusion drawn was that they must accumulate dollars infinitely by maintaining a current account surplus. The combination of these two factors led to an unprecedented expansion of the U.S. external deficit.”

The view that excessive reserve accumulation exacerbates global imbalances is often encountered, as expressed by economic journalist Matthew C. Klein and Peking University finance professor Michael Pettis. Of course, not all reserve accumulation is driven by considerations of financial stability and dollar shortages; exchange rate controls and trade policies are also motivating factors. However, Wolf accurately points out the self-insurance attribute of reserve accumulation — it is a means of building defensive fortifications.

A recent study by Princeton University scholar Haillie Lee and Stanford University professor Phillip Lipscy shows that the reserve accumulation in East Asia (a region with large surpluses and reserve holdings) that began in the late 1990s is driven more by self-insurance motives than by mercantilist trade policies. This aligns with private conversations I had with central bank officials who were also severely affected by the Asian financial crisis. Although they are not pleased with the dollar’s central position, they have to face reality and believe that the International Monetary Fund (IMF) will not come to their aid (or that the conditions will be too harsh), and they do not expect to obtain Federal Reserve swap lines. Therefore, the conclusion is: they must accumulate dollar assets either individually or in conjunction with Southeast Asian countries.

If IMF assistance or swap agreements cannot be obtained, the accumulation of reserves will inevitably worsen. This means that risk countries intend to maintain trade surpluses to enrich reserves, thereby fueling the U.S. capital account surplus (which also expands the trade deficit when other conditions remain unchanged). As Wolf said, resolving global trade conflicts relies on structural adjustments in the international monetary system.

Solutions may include strengthening the IMF’s role in the global financial safety net (which may be opposed by the Trump administration), expanding the scale of swap agreements (also not favored by Trump), or replacing the dollar’s status as a reserve currency (even less desired by Trump), which can be termed as the “Trump’s trilemma.”

Expanding the Federal Reserve’s swap agreement network helps alleviate foreign demand for dollars, but it is not a panacea. Monetary policy experts Michael Bordo and Bob McCauley point out that since the 2008 crisis, foreign official holdings of dollar assets have only accounted for a small portion of the financing of the U.S. current account deficit. Central bank swap agreements can only alleviate the dollar asset demand of official holders (central banks, sovereign wealth funds, and other reserve management institutions). Although data tracking is difficult, over the past decade, the incremental increase in U.S. Treasury holdings by foreign private entities has constituted a major part of the total increase in foreign holdings (a similar trend exists for agency bonds). Swap agreements are powerless in this regard.

In addition, the assumption of unlimited demand for dollar assets by foreign official investors is facing challenges. Recent reports indicate that one of the world’s largest official reserve management institutions, the State Administration of Foreign Exchange of China, plans to reduce its holdings of dollar assets, which is consistent with the long-term declining trend of the dollar’s share in global reserves.

Nevertheless, foreign official reserve management institutions remain important marginal buyers of dollar assets, accounting for about one-fifth of the total holdings of U.S. long-term securities last year. As long as the Federal Reserve’s swap agreements can alleviate the pressure on reserve management institutions to accumulate dollar assets, maintaining their availability aligns with the goals of the Trump administration. If the U.S. refuses to provide swap agreements while reducing foreign official holdings of U.S. Treasury bonds, it will weaken the United States’ position as a global supplier of safe assets.

If Washington really wants to give up its status as the issuer of the global reserve currency, forcing the Federal Reserve to withdraw from the swap agreements would be a step in that direction.