On June 10, 2013, Brazil’s central bank announced an allotment of 40,000 currency swap contracts at an auction. This was the second operation carried out in short order that month, following weakness in the real, Brazil’s currency (BRL), against the dollar. In order to forestall any further declines, central bank intervention has long been a frontline tool in EM arsenals.

But why swaps? After all, Brazil as many others in the same situation had spent about two decades amassing huge stockpiles of reserves. That was the key lesson they took from the 1997-98 Asian flu debacle. In this modern world of massive global flows, central banks would have to become equally massive.

This is why I refer often the pound crisis of 1992, particularly that one New York Times article and its apt description of what was an unappreciated monumental change:

The world’s currency markets, it seems, are no longer governed by central bankers in Washington and Bonn, but by traders and investors in Tokyo, London and New York, as the chaos in the currency markets this past week has shown.

It was an interesting footnote to the UK’s struggles earlier in that decade, but after Asia was wiped out later on in the same one the world began to play catch up. That was the thing about the 2008 panic – it showed that they never really did catch up to the global system, only that they thought they had.

The EM’s quick recovery from the global Great “Recession” furthered that illusion. When the 2011 crisis struck, a second in the eurodollar system, they were just as unprepared by underestimating the severity, discounting its global reach, and more than anything failing to realize the chronic nature of the monetary reverse.

The problem with mobilizing reserves is domestic money supply. This is not a new phenomenon, and the links between dollar flows, now “dollar” flows”, and local money well-established. Using anyone’s reserves, selling UST’s, if you will, transfers the external funding shortage onto the domestic economy (just ask the Chinese).

A currency swap is a way to circumvent the full range of consequences when confronting an external pressure. At least that’s what these central bankers think. Here’s Banco Central do Brasil stating (in the form of a working paper study) in July 2013 its rationale for swaps over reserves:

A well known advantage of issuing such contingent liabilities as currency swaps is that authorities become able to intervene in the exchange market indirectly, without affecting the money supply or varying the stock of foreign exchange reserves.

You can manipulate the currency at the same time keeping forex reserves in reserve. “In other words, to some extent, the large holdings of international reserves provided an insurance, as well as the means to fight eventual adverse movements for the Central Bank.” Swaps move the currency in the direction desired while the stockpiles of mostly US$ assets sit menacingly warning any speculators who might challenge the central bank of its ultimate resolve.