What is the Exchange Stabilization Fund (ESF)
The Exchange Stabilization Fund (ESF) is a U.S. Department of Treasury emergency reserve fund which includes holding of U.S. dollar (USD), other foreign currencies, and special drawing rights (SDR) funds. These funds allow the Treasury to intervene in the foreign exchange (FX) marketplace to promote stability in both foreign and domestic currencies.
BREAKING DOWN Exchange Stabilization Fund (ESF)
The Exchange Stabilization Fund (ESF) allows the U.S. Treasury to intervene in the forex market to influence exchange rates. Usually, only the central bank of a nation will take such actions to control the exchange rate of their currency. Due to the interconnection of currencies in the FX market, volatility in one currency can spread to affect others.
One of the primary features of the Stabilization fund is its role in working with the International Monetary Fund (IMF) through the Treasury's special drawing rights (SDR). Special drawing rights (SDR) refer to an international type of monetary reserve pseudo-currency built from a basket of leading national currencies, backed by the full faith and credit of the member countries' governments. These funds may be added to existing foreign currencies to impact the exchange rates in the forex.
The Treasury can convert SDR funds into dollars by exchanging them with the Federal Reserve, 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 transactions.
Creation of the ESF
The U.S. Exchange Stabilization Fund 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, the use of ESF can buy or sell foreign currency and help with financing foreign governments. Interventions in the FX market began in 1934 and 1935. Since that time, the Exchange Stabilization Fund assisted in many loans to governments and central banks.
The Exchange Stabilization 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 U.S. Exchange, Stabilization Fund. The move was controversial and scrutinized by the United States House Committee on Financial Services.
In 2008, the Treasury Department pledged funds from the U.S. Exchange Stabilization Fund 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.