UC San Diego

Over the last two decades, the global financial architecture has been fundamentally transformed. There has been a significant rise in bilateral currency swap agreements (BSAs) – either in place of or in conjunction with traditional multilateral lending. Despite their recent popularity, BSAs are not well understood as a form of monetary cooperation and exhibit a number of peculiarities that on face should be counterproductive for global financial stability. Conventional wisdom suggests that BSAs should be highly political and therefore, create perverse incentives for recipients to behave in economic mismanagement. Unlike IMF loans, however, BSAs lack any explicit conditionality to attenuate the moral hazard problem. What explains why providers would offer BSAs given these risks? Further, what are the consequences for global financial stability? I argue that rather than a source of enhanced risk-taking, geopolitics may enhance financial stability by enabling providers to offer swap agreements where they otherwise might be hesitant. I first present a formal model of the provider-recipient interaction that highlights additional risks that providers face when extending BSAs to recipients who decline economic reforms. In contrast to previous work, I demonstrate that providers can use political ties to manage these risks: international linkages enable providers to credibly threaten punishment and thereby induce better behavior from swap recipients. By leveraging the political ties of their home countries, providers can extend BSAs to recipients whose requests they would otherwise reject and can reduce the long-term risk of economic collapse and spillover. I provide empirical support for the mechanism using a newly-created dataset of all swap agreements offered by the U.S. Federal Reserve, the People’s Bank of China, and the Bank of Japan between 2000 and 2016.