Tuesday, 7 April 2009
Currency Swaps Cut Exchange Rate Risk
Call it a currency exchange or a currency swap, the concept is similar: Two market players exchange equivalent sums of capital at the beginning of a set time period and return the principal plus interest when the period ends. The goal is to leverage each party’s comparative advantage, diversify financing, reduce financing costs, control exchange rate risks and improve the financial structure.
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Currency Swaps Cut Exchange Rate Risk
Caijing
7 April 2009
Call it a currency exchange or a currency swap, the concept is similar: Two market players exchange equivalent sums of capital at the beginning of a set time period and return the principal plus interest when the period ends. The goal is to leverage each party’s comparative advantage, diversify financing, reduce financing costs, control exchange rate risks and improve the financial structure.
Since the global financial crisis has exacerbated the potential for exchange rate fluctuations, reducing exchange rate risks has been a key reason for currency swap agreements.
Caijing learned that currency swap agreements signed in recent months between China and several countries are based on fixed exchange rates, with rates for initial periods set according to spot market rates at the time when agreements were signed. To compensate for exchange rate fluctuations, the swap agreements include requirements for the monitoring the macroeconomic circumstances of each of China’s swap partners, a partner’s foreign exchange reserves, and international balance of payments conditions.
Chinese swap partners who do not use the yuan they received, bank officials say, need not pay any interest. Otherwise, they must pay based on the Chinese interbank spot market interest rate.
Any additional interest charges depend on conditions spelled out in each agreement. Moreover, a partner’s central bank must seek permission from the Chinese central bank whenever it wants to allocate yuan.
Currency swaps inherently involve credit risk, bank officials say. But they sidestep exchange rate risk.
“We sign fixed exchange rate agreements,” the bank official said. “Regardless of whether currencies appreciate or depreciate against each other, money is returned at the exchange rate from the initial period.
If a Chinese partner country “is unable to return the money at that exchange rate, its currency acts as collateral and remains in China’s central bank. It can be used by China to buy goods from that country,” the official explained. “So even if dangers arise, most of the yuan originally swapped should be recoverable.”
China may also choose to increase an interest rate. “Because risk varies from country to country, interest rates can be raised in various amounts as well,” the bank official told Caijing.
The official also explained that currency swaps are different from basic loans because of the collateral factor. During the 1997 Asian financial crisis, China loaned US$ 1 billion to Thailand without collateral.
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