Central banker to the world: Foreign reserve management and U.S. money market liquidity

We develop a model that shows how foreign reserve management decisions can adversely affect U.S. money market liquidity. Consistent with the March 2020 dash-for-cash, our model suggests that as export-price volatility increases, a foreign central bank that pegs its exchange rate shifts reserves from relatively illiquid Treasuries to the Fed’s reverse repo facility. Over the relevant horizon, this precautionary behavior drains liquidity from U.S. money markets and raises repo spreads. These predictions provide a credible channel to identify the effect of foreign central bank demand for dollar liquidity on repo spreads, exploiting the characteristics of commodity exporters with pegged exchange rates. Empirical evidence supports the model’s predictions: precautionary sales by these central banks lead to a statistically and economically significant widening of repo spreads, accompanied by a drawdown in Treasury balances. These results underscore how the Fed’s foreign-repo facilities mitigate global dollar-funding stress and protect U.S. short-term funding markets.