December 1999

Federal Reserve Bank of Cleveland

The Exchange Stabilization Fund: How It Works

By William P. Osterberg and James B. Thomson

The increased turmoil in international ■ An Overview of the ESF financial markets, starting with the Asian The ESF began operations on April 27, crises of 1997, has led to calls for finan- 1934, with capital of $2 billion. Initially, Increasingly controversial, the cial assistance from the wealthier nations. $1.8 billion of the ESF’s reserves were Exchange Stabilization Fund is In December 1997, the United States an- maintained in the Treasury’s gold used to influence the international nounced a $5 billion commitment toward account. The remaining $200 million value of the U.S. dollar and to pro- an international package of financial as- was deposited in a special account at the vide aid to foreign countries. The sistance for South Korea. Two months Federal Reserve Bank of New York as debate surrounding the Fund will earlier the United States pledged $3 bil- the working balance for investing in become more informed, suggest the lion for assistance to Indonesia. In both gold and foreign exchange.2 The work- authors, when observers understand instances, the Exchange Stabilization ing fund of the ESF has expanded over how to calculate the total amount of Fund (ESF) was to be involved. time, reaching as high as $42 billion in mid-1995.3 As documented by Schwartz resources available to the Fund. This Established by Congress in 1934 to help (1997), most of the growth in ESF assets Economic Commentary explains how stabilize the international value of the has occurred since 1960 and has com- the ESF’s balance sheet figures must dollar, the ESF received little public prised increases in foreign exchange and be adjusted to produce an accurate attention until it was used in the provi- securities. As of June 30, 1998, almost account of those resources. sion of financial assistance to Mexico in 60 percent of the asset total had been the wake of the peso crisis of 1995. financed by cumulative net income, Indeed, greater scrutiny may have been mainly reflecting interest earnings and “… a loan or credit to a foreign entity or inevitable given the ESF’s expansion capital gains on foreign currencies. government of a foreign country may be beyond its original mandate.1 Despite the made for more than 6 months in a 12- recent attention, the full range of ESF The Gold Reserve Act of 1934 excluded month period only if the President gives activities and the actual amount of avail- the ESF from the congressional appro- Congress a written statement that unique able ESF resources are not well under- priations process and explicitly autho- or emergency circumstances require the stood. This impedes an informed public rized it to operate without congressional loan or credit be for more than 6 months discussion of ESF operations. oversight and accountability. In other (31 U.S.C. 5302(b)).” words, Congress gave exclusive control A major goal of this Economic Commen- of the ESF to the executive branch. All Finally, 1978 legislation requires the tary is to facilitate accurate assessments decisions regarding the ESF are made by Treasury to provide monthly statements of the amount of resources available to the Secretary of the Treasury, subject to of ESF activities to the House and Sen- the ESF. First, in order to understand the the approval of the President. uses of ESF resources, we provide an ate Banking Committees. Nevertheless, overview of ESF operations. Second, we Legislative changes in the late 1970s re- none of these legislative changes has examine the ESF balance sheet to show duced somewhat the secrecy under which reduced the discretion of the Treasury how “total assets” is a poor measure of the ESF operates and made it more ac- Secretary in operating the ESF. All of his the resources available to the ESF for one countable to the Congress. For instance, decisions are final and not subject to of its major activities, foreign-exchange since 1979 the administrative expenses of approval by the Congress. intervention. Third, we discuss how any the ESF have been subject to the budget ■ The Size of the ESF measure of ESF resources must take process. Moreover, a 1977 amendment to A common misperception about the ESF account of warehousing and swap lines. Section 10 of the Gold Reserve Act pro- is that its size is adequately measured by Finally, we suggest a better procedure for vides that: assessing the amount of resources avail- the “total assets” number reported on the able to the ESF. ESF balance sheet, published quarterly in

ISSN 0428-1276 the Treasury Bulletin (see table 1).4 This TABLE 1 ESF BALANCE SHEET, JUNE 30, 1998 might seem to be a reasonable presump- tion since the ESF cannot unilaterally Assets ($ millions) Liabilities and capital ($ millions) issue debt in financial markets. However, Held with U.S. Treasury: Current liabilities: U.S. government securities 15,691 Accounts payable 223 several important aspects of ESF opera- Total current liabilities 223 tions are not apparent from its balance Special drawing rights (SDRs) 10,001 Other liabilities: sheet. In particular, since many ESF Foreign exchange and securities: SDR certificates 9,200 operations use dollar assets, any limita- German marks 5,898 SDR allocations 6,524 tion on the conversion of nondollar assets Japanese yen 8,018 Total other liabilities 15,724 to dollar assets is relevant to an assess- Accounts receivable 119 Capital: ment of available ESF resources. Capital account 200 Net income gain (+) or loss (–) 23,581 Intervention, the purchase or sale of for- Total capital 23,781 eign currencies to influence the interna- Total Assets 39,727 Total liabilities and capital 39,727a tional value of the dollar, is a major use of ESF resources (see box, opposite). a. The column sum does not equal this number because of rounding error. SOURCE: U.S. Department of the Treasury, Treasury Bulletin, December 1998, p. 108. The other is the provision of financial assistance to foreign countries. When- ever the ESF sells foreign currency, it produces a crediting of the ESF’s (non- There are three SDR entries on the ESF an estimate of the ESF’s available re- marketable) U.S. government security balance sheet (see table 1). The SDR sources. Thus, although total assets of account with the Treasury, which is asset entry and the SDR liability entry, the ESF on June 30, 1998, were $39.7 equivalent to “dollar” cash assets. When “SDR allocations,” pertain to ESF link- billion dollars, a slightly more accurate purchasing foreign currency, the ESF ages to the IMF. The allocations repre- measure of available dollars would be first obtains dollar balances—possibly sent the current value of the provisions of $30.4 billion. This is the sum of the non- by selling some of its Treasury securities SDRs by the IMF to the U.S. Treasury, monetized portion of the SDR total to the Treasury (with the Federal Reserve which were transferred to the account of ($10 billion SDRs minus $9.2 billion [hereafter, the Fed] acting as agent). The the ESF.6 The SDR asset entry reflects SDR certificates), the entry for U.S. subsequent purchase of foreign exchange the dollar value of SDR allocations to the government securities with the Treasury with dollars leaves the ESF with a lower United States plus interest earnings, valu- ($15.7 billion), and the dollar value of level of Treasury securities but an off- ation changes, and sales and acquisitions the German mark and Japanese yen setting increase in “foreign exchange of SDRs from other IMF participants. items ($13.9 billion). and securities.” The third entry, “SDR certificates,” ■ Off-Balance-Sheet Financing Thus the relevant measure of resources equals the portion of the SDR assets Congress limited the ability of the ESF available for ESF interventions depends which has already been “used.” As noted to issue liabilities on its own and thus, on whether foreign exchange is being earlier, all SDRs owned by the U.S. gov- perhaps intentionally, limited the ESF bought or sold. Dollar assets are needed ernment must be held by the ESF. In to financing new interventions through to buy foreign-currency-denominated other words, the ESF cannot engage in the sale of assets, a practice known as assets. On the other hand, purchases of transactions with either the U.S. Trea- asset management. However, beyond dollars are financed from international sury or the Fed that would result in a the uses of SDRs and securities as de- reserves, which include official holdings reduction in the ESF’s SDR holdings. scribed above the ESF can obtain addi- of gold, foreign government securities or Thus, in order to convert SDRs to dollar- tional dollar resources by moving for- deposits at foreign central banks, the denominated assets, the ESF issues a eign-denominated assets off-balance reserve position in the International claim on its SDR assets to the Fed— sheet through an arrangement with the Monetary Fund (IMF), and special SDR certificates—in a process called Federal Reserve System. Thus, the drawing rights (SDRs).5 monetization.7 While this does not $30.4 billion on-balance sheet asset decrease the SDR asset entry on the bal- number is still a flawed measure of the ESF accounting for SDRs provides ance sheet of the ESF, it does increase dollar assets available to the ESF. another example of why total assets is a the certificate number by the amount of poor measure of available resources. The the monetization. By law, the certificate The first problem is that, once the Treas- SDR is an international reserve asset cre- entry cannot exceed the SDR asset entry. ury securities (“dollars”) are exhausted, ated by the IMF (under the First Amend- However, up to the limit imposed by the the ESF cannot use its German mark as- ment to its Articles of Agreement) to SDR asset total, monetization increases sets or Japanese yen assets to purchase supplement existing reserve assets. The the size of the balance sheet, since the additional mark or yen items, respec- value of an SDR is determined by refer- certificate amount increases dollar for tively, without first converting them into ence to a basket of currencies of the five dollar with the eventual purchase of dollar-denominated assets. This con- largest industrial-economy member assets (for example, foreign-currency- version of the ESF’s foreign currency countries of the IMF. Pursuant to the denominated government securities).8 portfolio into dollar-denominated assets Special Drawing Rights Act of 1968, requires an off-balance-sheet financing SDRs allocated to the United States or Since the monetization process increases arrangement with the Fed, referred to otherwise acquired by the United States the total asset number while decreasing as warehousing. are resources of the ESF. the amount of SDRs available to be monetized, the certificate total must be subtracted from total assets to arrive at ■ THE FED AND THE ESF IN FOREIGN-EXCHANGE INTERVENTION Summary Since the ESF’s inception, the Federal Reserve Bank of New York has been the offi- The Exchange Stabilization Fund, under cially designated agent for the ESF in intervention operations. In 1962, the Federal the U.S. Treasury, is now routinely in- Reserve System’s Federal Open Market Committee (FOMC) authorized open-market volved in efforts to stabilize currencies transactions in foreign currencies for the account of the Fed, and since then, the Fed- and to provide financial support to for- eral Reserve Bank of New York has acted as agent for both the Fed and the ESF in eign countries. However, the amount of such transactions. Starting in 1978, the ESF and the Fed have almost always inter- resources available to the ESF and its vened jointly. range of activities are perhaps not well understood by many observers. In this Although the decision to intervene is usually made jointly by the Treasury and the Fed, Economic Commentary we correct the it falls primarily under the Treasury’s purview. While the two entities routinely inter- misperception that “total assets” is a good vene in the same direction and amounts for their individual accounts, formal indepen- measure of available ESF resources. dence is maintained. In other words, the Treasury can instruct the Fed to intervene on behalf of the ESF but it cannot force the Fed to intervene for the Fed’s own account.a First, “total assets” ignores the fact that the monetization of SDRs does not a. One exception to this would be a declared national emergency. See also Owen F. Humpage, “Institutional Aspects of U.S. Intervention,” Economic Review, Federal Reserve Bank of Cleveland, vol. 20, no. 1 (Quarter 1 decrease the SDR asset entry even 1994), pp. 2–19. though the total amount of monetization is limited by the SDR asset number. Con- sequently, total assets must be reduced by Warehousing is a swap transaction in The second problem with the on-balance- the outstanding amount of monetization, which the Fed buys foreign exchange sheet asset measure of ESF resources is measured by the SDR certificate number. from the ESF in a spot transaction and that it ignores swap lines. Swap lines, Second, estimates of resources available sells it back with a forward transaction formally called reciprocal currency to the ESF for intervention must take into —that is, the ESF agrees to exchange arrangements, are credit lines between account the warehousing arrangement dollar assets for foreign exchange on the governments (or central banks) stipulat- with the Fed. The current limit on the date the forward transaction comes due. ing terms which, usually for a short size of the warehouse is relevant to The ESF balance sheet would thus period of time, allow either country to whether the foreign-currency-denomi- record a decline in “foreign exchange borrow the other’s currency.11 The nated assets could be converted into dol- and securities” but an increase in the mechanics of drawing down a swap line lars for use in purchasing foreign assets. “U.S. government securities” total, are similar to that of warehousing—off- Third, outstanding swaps and any exist- which could be used to purchase foreign setting spot market and forward market ing commitments of ESF funds should be currency or implement dollar loans to transactions—except that our swap lines reflected in estimated ESF resources. An foreign countries (the forward transac- do not provide us with dollar assets understanding of these points is a prereq- tion would not appear). In other words, directly but rather provide dollar assets uisite to an informed debate regarding the Fed warehousing arrangement for the other country. As in the ware- any change in ESF funding. allows the ESF to take a leveraged posi- housing arrangement, the forward mar- tion in foreign assets that is not reflected ket transaction does not appear on the ■ Footnotes on the ESF’s balance sheet. balance sheet until the expiration of the 1. See Anna J. Schwartz, “From Obscurity to Notoriety: A Biography of the Exchange Sta- swap line.12 Drawings might be Two factors complicate the ESF’s ability bilization Fund,” Journal of Money, Credit, renewed once routinely, but statutes and Banking, vol. 29, no. 2 (May 1997), pp. to use the Fed warehouse. First, the size require that the executive branch report 135–53; Walker F. Todd, “Disorderly Mar- of the warehouse is determined by subsequent renewals to Congress. Both kets: The Law, History, and Economics of the FOMC deliberations. Although the size the Fed and the ESF maintain swap lines Exchange Stabilization Fund and U.S. For- of the warehouse was increased to $20 the sizes of which are indicated in the eign Exchange Market Intervention,” Re- billion to help finance the Mexican fi- quarterly summary of ESF and Fed for- search in Financial Services Public and Pri- nancial assistance package in 1995, it is vate Policy, vol. 4 (1992), pp. 111–79; and eign exchange operations published in C. Randall Henning, “The Exchange Stabi- currently limited to $5 billion with no the Federal Reserve Bulletin. As of lization Fund: Slush Money or War Chest?” balances currently outstanding. Second, March 31, 1999, the only authorized Institute for International Economics, Wash- although the currencies currently eligible ESF swap line was with the Bank of ington, D.C., 1999. for the warehouse are indicated in the Mexico for $3 billion.13 Authorization for Foreign Currency 2. Although originally authorized to deal in both gold and foreign exchange, the ESF has Operations, they are not necessarily the Finally, any measure of ESF resources tended to deal primarily in foreign exchange same as the currencies that the ESF available for intervention needs to take and, to some extent, in the securities of sov- 9 needs to exchange. account of any stated commitments by ereign nations (including U.S. government the U.S. Treasury to provide financial securities). Since about 1978, warehousing has been assistance to foreign governments via controversial. Goodfriend (1994) argues the ESF. For instance, the commitments 3. See Schwartz (footnote 1), pp. 136–7. currency-warehousing agreements that had been made to Korea and 4. For example, a December 4, 1997, article between the ESF and the Fed provide Indonesia would have reduced the total discussing the proposed rescue plan for South the ESF with additional funding that cir- resources available for intervention as Korea states that “the U.S. money, if needed, cumvents the congressional appropria- reflected on the June 30 balance sheet would come from the Exchange Stabilization tions process and statutory limits on by $8 billion.14 Fund…. The fund contained $40 billion as of Federal borrowing.10 the end of March….” See “South Korea, IMF Finalize $55 Billion Bailout Plan,” Los Ange- les Times, p. D1. 5. The U.S. drew on its IMF quota in Intervention,” Economic Review, Federal Re- the ESF still provides backstop to the Bank 1964– 66, 1968, 1970–72, and 1978 for serve Bank of Cleveland, vol. 30, no. 1 (Quar- of International Settlements’ $7.5 billion dol- amounts totaling $6.5 billion. Treasury secu- ter 1 1994), p. 5. lar support package for Brazil. rities denominated in foreign currencies were issued in 1962–74 (“Roosa” bonds ) and in 10. See Marvin Goodfriend, “Why We 1978–79 (“Carter” bonds) for $11.1 billion. Need an ‘Accord’ for Federal Reserve Credit See Schwartz (footnote 1), pp.143–4. Policy: A Note,” Journal of Money, Credit William P. Osterberg is a senior economist at and Banking, vol. 26 (August 1994, Pt. 2), the Federal Reserve Bank of Cleveland, and 6. These IMF provisions of SDRs to the U.S. pp. 572–80. James B. Thomson is a vice president and Treasury occurred in four separate actions economist at the Bank. The authors are between 1970 and 1981. 11. See Humpage (footnote 9), pp.7–8, for further details on the accounting associated grateful to Tim Dulaney, Owen Humpage, 7. The last big cash-in, or conversion of, SDRs with swap lines. Dino Kos, and Walker Todd for numerous was in the third quarter of 1995 to fund part of helpful comments and suggestions. the financial assistance offered to Mexico. 12. Because a forward transaction commits The views stated herein are those of the the ESF to exchange foreign currency for authors and not necessarily those of the Fed- 8. The conversion of SDRs first augments the dollars at a fixed price in the future, the true eral Reserve Bank of Cleveland or of the asset-side entry for U.S. government securi- exposure of the ESF to foreign-exchange risk Board of Governors of the Federal Reserve ties. This entry, plus “foreign exchange and is not reflected on its balance sheet. System. (foreign government) securities” more directly permits the funding of ESF activities 13. In the last quarter of 1998, Federal Economic Commentary is published by the such as the purchase and sale of foreign cur- Reserve System swap lines were reduced Research Department of the Federal Reserve rencies. For example, U.S. government secu- from $32.4 billion to $5 billion ($2 billion Bank of Cleveland. rities can be used to purchase foreign cur- with the Bank of Canada and $3 billion with To receive copies or to be placed on the rency as part of an effort to depress the the Bank of Mexico), and the ESF eliminated mailing list, e-mail your request to 4d.sub- international value of the dollar. This would its swap line with the German Bundesbank. [email protected] or fax it to 216-579- then add to the foreign exchange total, which There are no outstanding swaps for either 3050. Economic Commentary is available at is largely held in the form of foreign currency agency. Reasons stated for the reductions the Cleveland Fed’s site on the World Wide government securities, rather than cash. included history of disuse, formation of the Web: www.clev.frb.org, where glossaries of European Central Bank, and the existence of terms are also provided. 9. The authorization is published annually in other arrangements for monetary cooperation. Annual Report of the Board of Governors of We invite comments, questions, and sug- the Federal Reserve System. See also Owen F. 14. The commitments to Korea and Indone- gestions. E-mail us at [email protected]. Humpage, “Institutional Aspects of U.S. - sia and also to Thailand have since been ren- dered inoperative. However, as of June 1999,

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