The initiative, which entails temporarily swapping dollars for foreign currencies, also involves the central banks of Britain, Switzerland and Japan, underlining the extent of international concern about Europe’s deteriorating financial system. By tapping the Fed for dollars, the other central banks are taking advantage of long-standing arrangements, first put in place four years ago at the outset of the global financial crisis to prevent bank lending from freezing up.
Global stock markets surged on the news of this coordinated response by some of the world’s leading central banks. The Standard & Poor’s 500-stock index in the United States rose 1.7 percent Thursday, and the German stock market closed up 3.2 percent. Asian markets rose in early Friday trading, with Japan’s Nikkei 225 index up 1.7 percent at midday. The value of the euro currency rose on greater optimism that the European debt crisis can be resolved.
At the heart of Europe’s financial problems are the hundreds of billions of dollars in risky government bonds held by the banks. Those bonds were issued by cash-strapped governments, like those of Greece and Portugal, and if they default, the banks could face massive losses. As concerns turn to the health of the banks themselves, investors are becoming wary of lending them money, at least at the previously low rates.
The Fed will make short-term dollar loans to the ECB and other central banks through “swap lines,” swapping dollars for an equivalent amount of euros, British pounds, Swiss francs and Japanese yen. The ECB will, in turn, make those dollars available to euro-zone banks, the Bank of England to British banks, and so on, in the form of three-month loans at a fixed interest rate.
While these loans will not ease any losses the banks could suffer from a default, say, by Greece, the initiative lubricates the European financial system, preventing temporary shortages of cash from further weakening the banks and choking off growth.
This step comes at an especially delicate moment for the banks as they prepare for the end of the year. Traditionally, as they get ready to publicly report their financial positions, banks have shifted into cash and away from riskier assets as a way of buffing their appearance. This year, however, cheap dollars are increasingly hard to come by.
European banks have traditionally raised dollars by borrowing from U.S. money market funds. But those funds have cut back, responding in part to the anxiety of their own investors.