by Zach Fry, Program Manager, Bretton Woods Committee & Tenley Smith, Senior Program Associate, Bretton Woods Committee

The interconnected and international nature of today’s global financial system has brought many positives. One downside, however, is that shocks today are easily transmitted across borders at high speeds. The way shocks become crises and their potential effects are covered in another BWC Backgrounder, How Does Financial Risk Become Financial Crisis? When they do spillover and become international crises, there are several institutions that must be a part of the solution.

What are crises?

There are three main types of crises that sovereigns might encounter:

1. A balance of payments crisis in which countries lack the foreign currency needed to meet international payment obligations. This may be due to unsustainable domestic policies or extreme short-term financing needs, such as recovering from a natural disaster.
2. A sovereign debt crisis in which governments are at risk of imminent default on their debts. This could be due to a severe payments imbalance or heightened global risk aversion to issue new debt. Sovereign debt crises are in many ways unique challenges, not only because each sovereign’s balance sheet is different, but because each sovereign’s debt is made up of a complex web of creditors. As a result, sovereign debt crises often require multilateral coordination and international cooperation to restructure debt and attain financial and economic stability.
3. A foreign currency (FX) liquidity crisis in which banks or other financial system participants cannot access adequate short-term funding in foreign currency to fulfill a transaction.

In practice, however, these types of crises can be concurrent or influence each other. For instance, at the onset of the COVID-19 pandemic, balance of payments and FX pressures both existed.

What tools do we have to respond to crises?

While prudent domestic fiscal policy is foundational to stemming off an economic crisis, sound domestic policies alone may not always be sufficient. Countries might need to take extraordinary national measures or look outside their borders for help.

1. At the national level: Countries self-insure using foreign currency reserves or fiscal space.
2. At the bilateral level: There are swap lines conducted bilaterally among central banks which enable them to exchange their currencies in order to meet short-term liquidity needs of a sovereign.
3. At the regional level: Regional Financing Arrangements allow countries to draw on pooled resources during times of crisis.
4. At the international level: The IMF provides a global financial backstop.

International reserves are the first line of defense in a crisis but are earned through balance of payments surpluses. Backstops to borrow reserves in an emergency at reasonable cost include IMF financing, bilateral swap lines, and regional financing arrangements. Although the latter two have grown considerably over the past two decades, they are still available only to a limited number of countries.

Which tools do we use for which crisis?

For Balance of Payments crises, where countries lack the ability to meet obligations, countries can turn to IMF programs specifically designed to provide medium-term financing linked to corrective economic policies. Regional Financing Arrangements can also provide additional pooled resources.

For Sovereign Debt crises, IMF programs with policy conditionality work to restore market confidence and provide bridge financing. But sovereign debt crises often require multi-party engagement of private and public sector creditors to restructure the sovereign’s debt and in some cases to obtain debt forgiveness.

For Foreign Currency (FX) Liquidity crises, central bank swap lines at the bilateral level are specifically designed to provide short-term foreign currency liquidity, particularly in US dollars. The U.S. Federal Reserve has been the most frequent and recent provider of these swap lines, underscoring its central role in stabilizing global US dollar funding markets during crises. The IMF can also provide emergency liquidity assistance through rapid financing instruments. Many low-income countries lack access to bilateral swap lines and regional arrangements, making the IMF the primary international backstop for most nations. This creates a two-tiered system where some countries have multiple options while others rely primarily on the IMF.

What is the role of coordination?

It’s important to note that just as crises often occur concurrently, these tools too work best in combination rather than isolation. The choice of tools depends on crisis severity, country characteristics, and access to different mechanisms. Countries may need to deploy multiple tools simultaneously. A sovereign debt crisis, for example, might trigger balance of payments pressures, requiring both IMF programs and potential debt relief mechanisms.

While some of these tools overlap, they also come with constraints that may lead to some countries choosing certain tools over others. IMF programs, for instance, typically come with policy conditionality, while bilateral swap lines may have fewer strings attached and different institutions may have varying requirements or policy prescriptions that could conflict. There are also political considerations at play, as countries with access to multiple mechanisms must choose how to sequence or combine their use, and this may influence whether countries prefer bilateral/regional solutions over multilateral IMF support.

Featured author: 

Zach Fry, Program Manager, Bretton Woods Committee & Tenley Smith, Senior Program Associate, Bretton Woods Committee