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Central Banks Prepare to Distribute Foreign Currency at Home

The Federal Reserve and five other central banks set up agreements to distribute each other’s currencies in the event of a global funding crisis.

Central banks agreed to establish temporary bilateral currency swap arrangements “so that liquidity can be provided in each jurisdiction in any of their currencies should market conditions so warrant,” the Fed said today in a press release, calling the agreement a “contingency measure.” The European Central Bank and the central banks of Canada, Japan, Switzerland and the U.K. agreed to the arrangements.

The bilateral agreements were announced alongside coordinated action by the six central banks aimed at boosting dollar liquidity. Bilateral swaps would enable, for example, the Fed to provide euros, Swiss francs, or British pounds to U.S. banks if needed. The accord allows a broader distribution of liquidity and allows a bank to deal directly with its home central bank, said Dino Kos, a former New York Fed executive vice president in charge of open market operations.

“At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar,” the Fed said in a statement. “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.”

Michael Feroli, chief U.S. economist at JPMorgan Chase & Co., called the bilateral arrangements “a novel step and a curious feature of today’s announcement” that “are apparently being set up as a backup plan in the event of a worsening in global financial conditions.”

Tighten Funding

A sovereign default in Europe, for example, could tighten funding for hundreds of banks around the world. So rather than European operations of Citigroup Inc. or Morgan Stanley seeking euros from the ECB, the Fed could contribute to euro liquidity by doling out loans to those institutions in the U.S.

The central banks also agreed today to lower the cost of dollar swap arrangements. The premium banks pay to borrow dollars overnight from central banks will fall by half a percentage point to 50 basis points. A basis point is 0.01 percent.

The cut in the dollar swap rates is a message from central banks that says, “Please use it, and we are going to make it cheaper for you to use,” said Kos, now a managing director at the New York research firm Hamiltonian Associates Limited.

The dollar swap lines will be extended by six months to Feb. 1, 2013. The new pricing will be applied to operations starting on Dec. 5. The bilateral swap agreement is also in place through Feb. 1, 2013.

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