This Alternative to Traditional Currency Swaps... Also Used in U.S. Backyard Crises [Why&Next]

South Korea and the United States are finalizing a plan to use the U.S. Treasury's emergency foreign currency reserves, rather than a traditional central bank currency swap, to arrange investment funds for the United States. In the process of investing 350 billion dollars in the United States, the plan is for the U.S. to directly provide dollar liquidity using Korean won as collateral. The source of the dollar supply is the Exchange Stabilization Fund (ESF) operated by the U.S. Treasury Department. Initially, South Korea proposed an unlimited central bank currency swap, where the Bank of Korea would deposit won with the U.S. Federal Reserve (Fed) and borrow dollars. However, a currency swap led by the Fed would require the Fed to go beyond its legal responsibilities and allow a swap for investment support purposes. Additionally, the short maturity of one to three months makes it unsuitable for securing investment funds that may need to be maintained for several years.

Yonhap News Agency

ESF as an Alternative to Unlimited Currency Swap Disagreements

The ESF is a type of emergency foreign currency reserve accumulated by the Treasury Department to stabilize the foreign exchange market. Similar to South Korea's Foreign Exchange Equalization Fund, it is considered a major dollar liquidity support fund alongside the Fed's currency swaps. While traditional currency swaps are centered on advanced economies and reserve currency countries such as those using the dollar, yen, or euro, the ESF has been used to respond to currency crises in foreign governments with close economic and diplomatic ties to the U.S.

The recent 20 billion dollar ESF currency swap agreement with Argentina is a prime example. The U.S. Treasury Department provided emergency liquidity to Argentina, which is experiencing a foreign exchange crisis, using ESF funds, and the Central Bank of Argentina provided pesos as collateral for the dollar loan. This move was driven by a political calculation to both block negative spillover effects from Argentina's economic instability on the U.S. market and to keep China's influence in South America in check.

On the evening of the 15th (local time), Koo Yoon-chul, Deputy Prime Minister for Economy and Minister of Strategy and Finance, met and held talks with Scott Vestment, U.S. Secretary of the Treasury, on the occasion of the G20 Finance Ministers' Meeting at the International Monetary Fund (IMF). (Source: Ministry of Strategy and Finance)

In the past, during the 1995 Mexican peso crisis, the United States also provided up to 20 billion dollars in liquidity through the ESF. This included a short-term swap allowing Mexico to borrow up to 9 billion dollars using pesos as collateral, and a five-year loan. In 1998, the U.S. provided 5 billion dollars to Brazil in the form of a multilateral guarantee, partially backing a Bank for International Settlements (BIS) guaranteed loan.

This was not a matter of giving special treatment to South American countries, but rather a strategy to prevent the risk of crisis transmission, such as a sell-off of U.S. Treasury bonds to secure dollars during a crisis or a massive influx of refugees. The ESF was also quietly used alongside the Fed's currency swaps to provide dollar liquidity to foreign banks suffering from dollar shortages during the 1997 Asian financial crisis and the 2008 global financial crisis.

Cash Investment Ratio Becomes Final Negotiation Issue

There are limits to supporting 350 billion dollars in liquidity solely through the ESF. According to the U.S. Treasury Department's website, as of the end of August, the ESF's total assets stood at 220.95977 billion dollars, with net assets of only about 43.4 billion dollars after subtracting liabilities of 177.56248 billion dollars. For this reason, it is reported that both countries are also considering other funding sources in addition to the ESF. They are also reviewing ways to spread out the timing of investments in long-term projects to minimize the impact on the foreign exchange market. Scott Vestment, the Treasury Secretary leading the U.S. tariff negotiations, said, "We are at the final stage of trade negotiations with South Korea," and added, "I am confident that the differences can be resolved."

The key issue is the cash investment ratio. While the demand for a 350 billion dollar upfront payment is expected to be withdrawn, the cash investment ratio is likely to be higher than the 5% initially targeted by the Korean government. Both sides are narrowing their differences and seeking common ground on the cash investment ratio. Excluding the 150 billion dollars earmarked for the Masga project out of the 350 billion dollars, if the remaining 200 billion dollars is invested in cash within the remaining three years of President Trump's term, 66 billion dollars must be raised each year. The maximum amount of dollars the Korean government can raise annually is only 20 billion dollars, which is about 5% of South Korea's foreign reserves of 422 billion dollars as of the end of September.

The Korean negotiation team currently visiting the United States reportedly visited the Office of Management and Budget (OMB) on the afternoon of the 16th (local time) to discuss the Masga project. Once the working-level negotiations are concluded, it is expected that the leaders of South Korea and the United States will sign a memorandum of understanding (MOU) at the Asia-Pacific Economic Cooperation (APEC) summit to be held in Gyeongju at the end of this month.