What is the Exchange Stabilization Fund (ESF)?

The Exchange Stabilization Fund (ESF) is an emergency reserve account that can be used by the U.S. Department of Treasury to mitigate instability in various financial sectors, including credit, securities, and foreign exchange markets.

Key Takeaways

  • The Exchange Stabilization Fund (ESF) is an emergency reserve account that can be used by the U.S. Department of Treasury to mitigate instability in various financial sectors, including credit, securities, and foreign exchange markets.
  • The Exchange Stabilization Fund (ESF) is, predominantly, comprised of three types of financial instruments, namely the U.S. dollar (USD), foreign currencies, and special drawing rights (SDR).
  • The Exchange Stabilization Fund (ESF) was created and financed by the Gold Reserve Act of 1934.

Understanding Exchange Stabilization Fund (ESF)

The Exchange Stabilization Fund (ESF) is, predominantly, comprised of three types of financial instruments, namely the U.S. dollar (USD), foreign currencies, and special drawing rights (SDR). For instance, if the U.S. Treasury needed to intervene in the foreign exchange (FX) marketplace to influence exchange rates and promote stability in both foreign and domestic currencies, then they could do so by using the ESF.

For example, due to the interconnected nature of the global currency market, volatility in one currency can quickly spread, and the ESF can be used to quell this turmoil. Usually, interventions are the bailiwick of central banks, but the ESF allows the U.S. Treasury to, for all intents and purposes, engage in what amounts to an intervention without having to seek the approval of the U.S. Congress.

One of the primary features of the Exchange Stabilization Fund (ESF) is that it includes SDRs, which is an international monetary reserve pseudo-currency created by the International Monetary Fund (IMF) in 1969 from a basket of leading national currencies and backed by the full faith and credit of the member nation's governments. This gives the U.S. Treasury a way to coordinate with the IMF if the need to stabilize exchange rates should arise.

The Treasury can convert SDR funds into dollars by exchanging them with the Federal Reserve (FED), the central bank of the U.S. SDR may be exchanged for USD, gold, or other international reserves held by the FED. Most central banks will maintain a supply of international reserves, which are funds that the banks can pass among themselves to satisfy global requirements.

Creation of the Exchange Stabilization Fund (ESF)

The U.S. Exchange Stabilization Fund (ESF) was created and financed by the Gold Reserve Act of 1934. The Act devalued the dollar relative to gold and took the U.S. off the gold standard. Because the move would undoubtedly destabilize international currency markets, the Act also authorized the secretary of the Treasury to use the stabilization fund to trade gold, foreign currencies, or foreign government debt to influence exchange rates.

Under direct authorization by the secretary of the Treasury, and with the approval of the president of the U.S., the ESF can buy or sell foreign currencies and help with financing foreign governments through short-term loans. Interventions in the FX market began in 1934 and 1935, and the ESF has provided loans to many governments and central banks since its creation.

Exchange Stabilization Fund (ESF) in Action

The U.S. government used the fund following the 1994 Mexican economic crisis to help stabilize the value of the Mexican peso. The Clinton Administration wanted to contribute $20 billion to a $50 billion plan to issue loan guarantees to the Mexican government to prevent a collapse of the Mexican economy. A Republican Congress, however, would not agree to appropriate the funds, so Treasury Secretary Robert Rubin decided to tap the ESF. The move was controversial and scrutinized by the United States House Committee on Financial Services.

In 2008, the Treasury Department pledged funds from the ESF to insure the money market mutual fund market, which had suffered a run on the fund following the collapse of investment bank Bear-Stearns. Participating money market mutual funds had to pay a fee to participate in the investment scheme, which helped boost investor confidence and stabilize the market for money market mutual funds.