CURRENCY SWAP AGREEMENT: A WORLDWIDE PRACTICE

MOHAMMED ARIFEEN
(feedback@pgeconomist.com)

Feb 27 - Mar 4, 20
12

A currency swap is an agreement between two parties to exchange the principal loan amount and interest applicable on it in one currency with the principal and interest payments on an equal loan in another currency. These contracts are valid for a particular period, which could lay out up to ten years.

A currency swap agreement determines the principal amount to be swapped, a common maturity period, and the interest and exchange rates determined at the commencement of the contract. Currency swap agreement is a worldwide practice at present.

Currency swaps were at first envisioned in the 1970s to evade foreign exchange controls in the United Kingdom. At that time, United Kingdom companies had to pay a premium to borrow in US Dollars. To ward off this, UK companies set up one after the other loan agreements with US companies wishing to borrow dollar.

Cross-currency interest rate swaps were brought in by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with an assumed amount of $210 million and for a period of over ten years.

During the global economic and financial crisis of 2008, the currency swap transaction structure was used by the United States Federal Reserve System to establish central bank liquidity swaps. The objective of central bank liquidity swaps is to provide liquidity in US dollars to overseas markets.

The benefits of currency swap are several. Speculators can gain from a favourable change in interest rates. It reduces costs and risks associated with the currency. Companies having fixed rate liabilities can capitalize on floating-rate swaps and vice versa based on the prevailing economic scenario.

On the other hand, the demerits of currency swap are also many. It is exposed to credit risk as either one or both the parties could default on interest and principal payments. Currency swap is susceptible to the central government's interference in the exchange markets. This occurs when the government of a country acquires huge foreign debts to temporarily support a declining currency. This leads to a large decline in the value of the domestic currency.

Recently, China and Turkey set aside their differences on how to deal with the furious violence in Syria and signed a three-year currency swap deal worth $1.6 billion to enable bilateral trade in local currencies.

The normalisation of trade between Pakistan and India after MFN decision would also set the way for trade in local currency between the two major member countries of the SAARC region. If the things go well, trading in local currencies with the regional countries would certainly provide a major relief to Pak rupee going forward.

A bilateral currency swap arrangement (CSA) was signed between the State Bank of Pakistan (SBP) and the Central Bank of the Republic of Turkey (CBRT) in a ceremony held on 1st November 2011 in Istanbul, Turkey by Governor SBP Yaseen Anwar and Governor CBRT Erdem Ba˛˝ in presence of the President Asif Ali Zardari and President Abdullah Gul of Turkey.

Under the arrangement, Pakistan and Turkey would finance two-way trade in rupee and lira worth one billion dollar per annum. It is expected that bilateral trade will increase between Pakistan and Turkey as a result of this agreement, further accelerating the economic ties between the two countries. This agreement will also make a substantial contribution in further strengthening the close and special relationship between the two countries.

President Asif Ali Zardari emphasized on the early finalisation of currency swap agreement between Pakistan and Sri Lanka to promote and facilitate bilateral trade between the two countries. It may be recalled that during the visit of President Zardari to Sri Lanka in November last, he had offered assistance to Sri Lanka in cement, sugar and dairy industries and urged the business community to take advantage of liberal trade policies of the country, through joint ventures and investment.

The recent expanded currency swap between South Korea and Japan is likely to boost the value of the Korean won and help reduce its volatility. Korea and Japan announced that they agreed to expand their currency swap volume to $70 billion from the current $13 billion as part of efforts to jointly stabilise financial markets amid lingering concerns over the global recession.

China and Indonesia agreed on a three-year currency swap deal worth 100 billion yuan or 175 trillion rupiah. The agreement aims to promote bilateral and direct investment between the two countries, and provide short-term liquidity to stabilise. The currency swap helps the Indonesian Bank to have sufficient funds to defend the peg.

China and the United Arab Emirates signed a multibillion-dollar currency swap deal in the latest indication of the growing political and economic links between Beijing and countries in the oil-rich Gulf region.

The swap valued at RMB35bn ($5.5bn), the latest in a string of currency deals China has agreed with foreign nations, is effective for three years and will allow the central banks to draw on the local currency facility to ease bilateral trading.

India and Japan signed a dollar swap agreement of $15 billion (Rs79,330 crore), whose immediate effect would strengthen this country in handling the tumbling rupee.

President Zardari proposed a currency swap agreement between Pakistan and Iran to further strengthen bilateral trade and economic ties between the two brotherly countries. The President made this proposal during meeting with Iranian President Mahmoud Ahmedinejad.

China announced a currency swap with Pakistan in a new step to gradually expand use of its tightly controlled yuan abroad. Beijing has begun allowing limited use of yuan in trade with Hong Kong and Southeast Asia in a move that could help to boost exports. It has signed swap currency deals with central banks in Thailand, Argentina and some other countries. The Chinese central bank said it agreed with its Pakistani counterpart to swap 10 billion yuan for 140 billion Pakistani rupees. It said the money would promote investment and trade but gave no details of how it would be used.

Expanded use of the yuan abroad would reduce costs for Chinese traders who do most of their business in dollars and euros. It also might increase the appeal of Chinese goods for foreign buyers who have yuan to spend. Beijing also has created a market for yuan-denominated bonds in Hong Kong.

Such above agreements no doubt give central banks access to each other's currency but commercial banks still need to create systems to issue letters of credit and handle other transactions in those currencies before companies can use them.