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Currency swap between central banks

| Updated: February 03, 2021 13:44:26

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Currency swap between central banks

Imports from abroad need payment settlement in currency other than in local currency. Countries having international currencies can import in their own currencies. US Dollars, Euro and some others have assumed the status of international currencies.

To avoid international currencies in settlement of trade, many emerging markets pursuing export-led development models arrange alternative solutions. Settlement by way of goods-to-goods is one of the best alternatives. But in reality, it is found to be a different solution in the name of currency swap offered by exporting country with importing countries.

Under swap arrangement, exporting countries extend credit facilities in their own currencies to importing countries. Importing countries use the swap loans for settlement of import payments by swapping local currency from importers' banks. The exporters' central bank makes export payments to exporters' banks out of the credit extended to the counterpart central bank.

The above transactions will be reversed when the swap loan recipient-countries export goods to their counterpart countries. In this situation, central bank will extend swap loans to its counterpart for arranging payments in local currency to exporters' banks as export proceeds. Counterpart central bank will receive payment against the credit from importers' banks in their country.

 In the above way, payment is settled primarily in local currencies through currency swap framework. The transactions do not need international currencies like US Dollar, Euro for settlement. Apparently, the mechanism looks good. But what needs to be addressed is its costs involved in the transactions. In this respect, there should be a win-win situation for both participating countries. Cost greater than benefit will not facilitate the transactional model under swap line.

What will be the costs against the arrangement is a question. Apparently, swap transactions lead two transactions for which one extends loan in its own currency to its counterpart. The recipient also extends the same loan in its own currency to its counterpart. One is, in this case, a lender as well as a borrower. Lending is extended in own currency, while borrowing is received in other currency. At the end of the maturity of the deal borrowing is repaid, lending proceed is received. The output of the deal is interest payment in counterpart currency and interest receipt in own currency. There is no harm provided the transactions result in squired position.

As per global norms in international currency swap framework, importing country will utilise swap credit line for settlement of import payment. For example: country B and country C sign a swap agreement under which country B will extend $ 100 billion to country C which will extend $ 10 billion to country B. The import by country B from country C is higher by ten times than what country B exports to country C. It means country B imports $ 10 billion from country C; it exports $ 1 billion (B$ 10 billion = C$ 1 x exchange rate 10, say), on the other hand. As stated earlier, currency swap bears costs. For better understanding, the benchmark interest rate of country B is assumed to be 6 per cent annually whereas it is 4 per cent in country C. It is evident from the above discussion that country B needs funded facilities of C$ 10 billion but it extends only C$ 1 billion (B$ 10 billion). The gap is huge due to imbalance in trade which results in interest cost of C$ 400 million to be borne by country B while receiving only C$ 60 million (B$ 600 million) from its swap lending to country C. The transactions result in net cost to country B is C$ 340 million, net of its interest income amounting to C$ 60.

Currency swap arrangement is required for maximum utilisation of local currency in international settlement. But imbalance in trade does not bring the fruits; rather country B, in our case, needs to settle C$ 9 billion and interest payment of C$ 340 million on maturity in equivalent international currency. As such, so called currency swap is not a win-win game for bilateral transactions due to imbalanced trades.

In the context of payment settlement mechanism, Bangladesh is a member country of Asian Monetary Union (AMU). Under the platform, Asian Clearing Union (ACU) works to settle among nine member countries -- Bangladesh, Bhutan, India, Iran, Maldives, Nepal, Myanmar, Pakistan and Sri Lanka. Transactions with Iran do not take place. Myanmar, it has been learnt, does not participate in the transactions. Trade payments are settled under SWAP facility. As per its website, every eligible participant is entitled to the facility from every other participant up to 20 per cent of the average gross payments (ACU dollar and ACU euro accounts collectively) made by it through the ACU mechanism to other participants during the three previous calendar years. The rate of interest chargeable on each drawal is equal to two months US Dollar or Euro or Japanese Yen LIBOR declared by the Inter-Continental Exchange, applicable for the concerned value date.

Under the ACU arrangement, importers' banks make fund available to their central banks. They post a payable entry favouring the recipient central bank which makes fund available to exporters' bank. The settlement takes place periodically for which the country in payable position needs to pay interest at rate of 2-month LIBOR in concerned currency. Bangladesh being in deficit position with major trading partner needs to bear such costs. Benefits are nothing but enhanced gross reserve for the time being during the period pending for settlement. After settlement of payment, the reserve comes to real position. So, what benefit the framework brings needs to be reviewed. What would be the net effect, if the settlement is in local currency? The answer should be that the cost would be higher since interest rate of local currency in our regional cases is higher compared to benchmark rate of international currencies. Considering foreign exchange market liquidity and international reserve height of the country, and also deficits in trade with major trading partners, there arises a question of the real utility of the payment mechanism. The consequence is that our persistent payable position will result in higher cost compared to any material benefits. On the other hand, no support is available for trading with, say, Iran due to non-operations of ACU for this particular country. With regards to Myanmar, draft arrangement between commercial banks works for trade without ACU settlement. As such, rethinking is needed for regional settlement mechanism considering cost factors.

To bypass the hegemony of king currencies, many currencies are trying to achieve international status. Such countries being advantageous in export trade with positive position are trying to arrange swap arrangements with countries depending on them for production inputs and finished goods. The framework of so called currency swap arrangements apparently looks fine. But it does not bring fruits for the country like ours whose balance of trade is in deficit territory with the swap offering countries.

Now comes the question whether currency swap is acceptable or not. Surely, the answer depends on its costs and benefits. To be in win-win situation, there should be a bilateral trade arrangement with quota ceiling so that trade gap reaches sustainable level. This trade arrangement will result in full utilisation of swap line in local currency by both countries. Interest costs of a country will, then, be offset by interest income. Insignificant balance out of the transactions needs to be settled at payment cycle through agreed international currency. This may benefit imports at prices comparatively lower to prices available at international currencies.

We need cost effectiveness to go into swap arrangements with trading partners for which there need to have bilateral win-win trade agreements. Otherwise, the economy will suffer by incurring unnecessary costs. As such, special care needs to be considered before looking into lucrative offers by counterpart countries in the name of so called currency swap. Central bank should be aware of such type of proposals from their counterpart for the sake of national interest.

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