Currency swap agreements have recently become an alternative method to confront financial crises, according to a research paper prepared by former Central Bank of Egypt Governor and professor of economics, Mahmoud Aboul Oyoun.
He explained that crises such as the 1997 East Asian financial crisis, the 2008 global financial crisis, the coronavirus pandemic, and the Ukraine war have taught the world that the traditional financial safety network based on Central Bank reserves or the International Monetary Fund‘s financing are not sufficient to confront issues such as liquidity crises, foreign currency shortages, and bilateral or global trade disruptions.
Currency swap agreements, whether bilateral or involving multiple parties, emerged as an alternative solution, he noted.
These agreements can only be financial, he explained, between central banks or between commercial banks.
According to the research paper, any country facing a foreign exchange crisis will resort to its currency foreign currency reserves, although these reserves cannot be withdrawn from at times.
Withdrawing from reserves impacts the exchange rate and the country’s classification.
Banks may resort to other correspondent banks, but the increase in risks resulting from the currency shortage makes it difficult to obtain the required financing.
Countries therefore may to the International Monetary Fund, but its conditions are not always acceptable as its financing is governed by the size of quotas and other factors. Currency swap agreements in this case serve to be a proper alternative.
What is a currency swap agreement?
Currency swap agreements are agreements to exchange two agreed upon quantities of each country’s currency, provided that it is recovered in the future on previously agreed upon terms.
The paper stated that among the most important conditions of swap agreements are trust between its two parties, freedom of movement of capital between the two contracting states, low risks of non-payment, and the presence of a good volume of commercial transactions between the two economies concerned, as well as banking relations between banks in the two countries.
The bilateral currency swap, according to the paper, is an extension of the concept of equivalent transactions in goods and services, but now wearing a monetary garb.
It was practiced by the US Federal Reserve with the German Bundesbank in the 1970s.
The World Bank conducted swap agreements in 1981 to obtain the German mark and the Swiss franc, and the Federal Reserve uses it on a permanent basis with a number of global central banks in what is known as the SBSA, so the practice has seen usage for some time.
Donor central banks resort to currency exchanges for the purposes of strengthening confidence in its currency, as well as to promote exports to countries that lack liquidity in foreign exchange, to support international financial stability, and when seeking to convert the national currency into a currency more acceptable at the global level – China is a model for this.
Receiving central banks resort to it with the aim of alleviating tension that local markets may face when there are gaps in demand for foreign exchange.
This is because local banks are unable to borrow from correspondents or because they are exceeding the safe ratios of assets and liabilities in foreign exchange, as well as to hedge against interest rate changes, improve the components of international reserve assets to match external debt repayment obligations, and provide financing for imports from a country.
In 2020, the French Ministry of Economy estimated that there were 40 central banks in the world that use currency swap agreements.
It estimated the number of swap agreements at 100.
Conditions
The general conditions for bilateral agreements to swap currencies are that the duration of the swap is not less than one year, usually ranging between three and ten years.
The interest rate may or may not be calculated on deposit balances, and the exchange rate for the swap is agreed upon upon contracting.
The country using the international currency bears the risks of fluctuations in the exchange rate of its currency against the currency of the donor country.
A certain period of time is available for the use of currency balances deposited with the two central banks that is less than the agreed upon period, and can be renewed.
If the agreements are for the purpose of financing trade, the Egyptian central bank tells the correspondent bank in the other country to pay the specified amount – in the currency of the correspondent bank’s country – to the exporting company in, for example, China and vice versa when there is a Chinese importer.
In the event that there is no Chinese importer, the account of the People’s Bank of China with the Central Bank of Egypt will not be affected, but the Chinese bank has the right to exploit the amount deposited in its account in investments in local debt instruments that generate a greater return for it.
In the event that the amounts in the accounts remain unused at the end of the agreement term, upon maturity all amounts exchanged may be repaid or the unused balances may be replaced.
