In a foreign exchange swap, two parties exchange specific amounts of two different currencies and repay the amount of the exchange at a future date, according to a predetermined rule reflecting both interest payments and amortization of the principal. Different types of foreign exchange swaps became fashionable in the 1980s and received much attention in the literature, most of it concerning the fast-growing interbank swap market. Less publicized, however, has been the fact that for several decades central banks have also used foreign exchange swaps to affect domestic liquidity, manage their foreign exchange reserves, and stimulate domestic financial markets. This paper describes the various ways in which central banks use foreign exchange swaps to achieve these goals.
The survey does not claim to be exhaustive, but rather illustrates all broad categories of central bank swaps (more elaborate evidence is given in Hooyman 1993). Information about central banks’ use of foreign exchange swaps is scarce since it usually does not appear on balance sheets, and central banks often keep their swap operations confidential in order to avoid adverse signaling effects. Furthermore, if data are available, their quality is often uncertain.
I. Foreign Exchange Swaps: Some Background Information
This section provides some general information about foreign exchange swaps and foreign exchange markets.
Definition and Pricing
In the 1980s, a common foreign exchange swap involved the exchange of interest payments over time, a transaction usually called a “currency swap.” For a much longer time, however, a simpler swap transaction has been used, in which only the principal amounts are exchanged on the initial and maturity dates at predetermined exchange rates. This latter kind of swap is the most relevant for this paper, since central banks use it more often than currency swaps.
According to the covered interest parity condition, the forward premium, or discount, reflects the corresponding differential between interest rates on the international markets, as risk-free arbitrage should ensure that no unexploited profit opportunities exist. This forward premium, sometimes called a swap premium or swap rate, is considered the price of the instrument. In countries with well-developed forward exchange markets, this price is market determined, and quotes can be obtained from commercial banks.
Currency swaps (like interest rate swaps and cross-currency interest rate swaps) are used by a wide variety of participants—banks, corporations, insurance companies, international agencies (the World Bank was a driving force in the development of the market), and sovereign states. There are four broad reasons to use swaps: (i) to exploit differences in credit rating and differential access to markets, thereby obtaining low-cost financing or high-yield assets; (ii) to hedge interest rate or currency exposure; (iii) to manage short-term assets and liabilities; and (iv) to speculate. Central banks have been known to use currency swaps for hedging and asset-liability management, but very rarely; hence, those operations will not be elaborated upon.
Central Bank Swaps in the Balance Sheet
When a central bank carries out a foreign exchange swap, it has significant economic effects. Suppose the Federal Reserve system buys foreign exchange with domestic currency and simultaneously agrees to sell the same amount of foreign currency at a certain date in the future at the forward exchange rate. As the Fed’s foreign assets increase, some items on the liabilities side must increase, depending on the counterparty. If the latter is another country’s central bank, this institution’s account at the Fed is credited, meaning that the Fed issues dollars and the other central bank issues its own currency. As long as both central banks do not spend the foreign currency, however, there is no effect on either currency in circulation or banks’ reserves, so both money supplies remain constant. If the counterparty is the banking system, banks’ reserves are credited with the domestic currency equivalent of the foreign exchange purchase, and banks’ foreign assets decline. Thus, reserve money increases, which normally causes an expansion of the money supply.
Another possible approach is to treat such swap operations as collateralized loans. In analytic terms, expansionary foreign exchange swaps with deposit money banks are similar to direct loans by the central banks. Depending on a complex of legal, historical, and institutional considerations, negotiable financial instruments may continue to be registered as assets in the balance sheet of the deposit money banks; their reserves item would increase and be balanced on the liability side by “central bank discounts received” (IMF (1984), p. 53). In this case, the central bank’s balance sheet shows an increase in domestic assets (claims on deposit money banks), not foreign assets. When the swap is unwound, both domestic assets and banks’ reserves return to their old levels, with an interest payment going into the central bank’s profit and loss account. This is the same amount as the interest earned on the foreign asset, adjusted for the difference between the spot and forward exchange rates.
Another consequence of the expansionary swap is the creation of a forward foreign liability for the central bank, matched by a forward domestic asset. This matched pair of contingent accounts can be recorded on or off the balance sheet, depending on the local practice. The four-entry system inflates and complicates the balance sheet, but it has the benefit of showing clearly which part of the foreign reserves is temporary, and therefore which exchange risk the central bank would be running if it lost its cover.
The swap in this example may not be intended as a money market tool; nonetheless, it still has the (temporary) expansionary effect on reserve money discussed above. Thus, if the swap was undertaken to gain foreign exchange or to provide banks with a forward cover, the consequent monetary expansion would have to be sterilized. In short, the goals for using foreign exchange are often conflicting.
A last topic to be discussed is the risk for the central bank in foreign exchange swaps. When foreign exchange swaps are seen as collateralized loans, normally there will be little risk: the central bank need not worry about default risk, since it has the collateral. Also, it is not exposed to exchange rate risk, as long as it has the foreign assets to cover the forward foreign liability (there is, of course, the risk of opportunity cost). There is exchange risk as soon as either the asset or the liability disappears—that is, if the counterparty defaults before the swap matures or if the central bank runs out of foreign exchange reserves. The latter situation has occurred in many countries and will be discussed in a later section. Finally, there is a settlement risk involved with swaps, as is always the case in any foreign exchange operation; the so-called Herstatt risk. However, the risk is very small.
Foreign Exchange Markets
In foreign exchange markets, spot transactions are settled on the second business day following trade. This is because the funds are ultimately transferred by having the central bank of the country issuing the currency transfer liabilities from the sending party’s account to that of the receiving party, and the two central banks may be in different time zones. The time difference also causes the (tiny) Herstatt risk, which occurs when one party is not able to receive the other party’s currency delivery lag. The delivery lag is made up by the time difference plus the difference between each country’s local time for final settlement. A central bank doing foreign exchange swaps is thus exposed to default risk by its counterparty, since after fulfilling its own obligation it has to wait several hours for payment.
In addition to dealing in the spot foreign exchange market, central banks engaged in foreign exchange swaps also enter the forward market. To be suitable for the use of swaps as a money market tool, this market should be deep, and quotes of the forward exchange rate should be readily available. The first criterion ensures that large transactions are not disruptive. The second requirement means that central banks should not be “making the market,” the price should be truly market determined. If the market were thin, and the rate were determined by the central bank, swap transactions could have disruptive effects on exchange rate expectations.1
II. Open Market Policy
In the following section, theory and facts are presented about the use of foreign exchange swaps as a money market tool in industrial and developing countries; such use differs noticeably between the two groups of countries.
In the past two decades, an increasing number of central banks in industrialized countries have included foreign exchange swaps among the instruments with which they fine-tune domestic liquidity, even though actual use of such swaps has remained limited in most countries.
As a result of the enormous increase in the volume, integration, and liberalization of international financial markets, and the emergence of new markets and instruments, a trend has developed for central banks to move from direct to indirect monetary policy. Instead of fixing of interest rates by administrative means or imposing controls, they increasingly use market-based instruments, such as open market operations. The bulk of these operations is in the form of central bank credit, but numerous other instruments are used.
Central banks employ foreign exchange swaps because (i) they prefer to have a wide range of intervention techniques at their discretion (possibly because they may wish to vary the predictability of their policy actions); (ii) in many countries the domestic short-term secondary market is not deep enough to permit market intervention, whereas the market in foreign exchange is generally active, making it possible to trade large volumes in any one deal; (iii) unlike outright foreign exchange operations, swaps have no direct effect on the spot (or forward) exchange rate;2 and (iv) swaps are flexible in that the technical procedures are informal and the swaps themselves are inconspicuous and easily reversible.
Possible drawbacks are that (i) foreign exchange swaps might influence the exchange rate because of a strong announcement effect; (ii) foreign exchange transactions take two days to become effective, which makes foreign exchange swaps less appropriate when swift action is required;(iii) in foreign exchange transactions there is no simultaneous exchange of one currency for the other, which gives rise to settlement risk;3(iv) often, there are only a limited number of large banks to act as counterparties—banks have to get the necessary dollars in the international market, and if the sum is large relative to their capital, a risk premium will be charged; (v) if active short-term securities markets exist, central banks often prefer to conduct their operations there; and (vi) if monetary policy targets interest rates instead of a monetary aggregate, allocation of central bank credit might be a more suitable instrument, since the immediate effect of swaps is on the high-powered money supply.
Since swap transactions are temporary by nature, they are suitable for short-term technical adjustment: either to influence the general liquidity of the market, so as to neutralize the effect of fortuitous or seasonal factors, or to bring about temporary market imbalances that can push interest rates in a desired direction. However, swaps can easily be rolled over for a longer-term effect, and the maturity of swap operations can be extended, the present range being from 24 hours to 24 months. Central bank foreign exchange swap operations may be conducted anonymously in the market at the usual maturities, but more flexible contracts may be concluded bilaterally with banks. They generally involve U.S. dollars.
Switzerland is the only country where foreign exchange swaps are the main instrument for the management of bank reserves, mainly because of the lack of short-term government securities (the Swiss government does not usually run a budget deficit). The total amount of swaps outstanding averages around 40 percent of the monetary base.
Apart from Switzerland, the two countries that rely most on central bank foreign exchange swaps are the Netherlands and Germany. In both, short-term securities markets are extremely thin, but the central banks use foreign exchange swaps infrequently because they rely on other open-market instruments. In Germany, foreign exchange swaps have been used by the Bundesbank since 1958. For the first decade, it used contractive swaps both to influence the domestic money market and to stimulate short-term foreign investment by offering attractive swap rates. From the late 1960s, swaps were motivated mainly by attempts to calm the international monetary situation and strengthen confidence in the dollar parity. Foreign exchange swap transactions have served the purpose of “fine-tuning” the money market only since 1979. Besides swaps, the Bundesbank carries out so-called foreign exchange transactions under repurchase agreements. These are essentially the same as swaps, but the ownership of the foreign asset does not change. Quantitatively, foreign exchange swaps and repurchase agreements have sometimes been of considerable importance for fine-tuning but do not make up a substantial part of the monetary base (Deutsche Bundesbank (1989), pp. 77–79).
The importance of the foreign exchange swap in the Netherlands was never great, and operations have ceased during the past few years (but are not officially abandoned). Other countries that have used currency swaps (albeit rarely) are the United Kingdom, Norway, Finland, Belgium, Ireland, and Austria (Bingham (1985), Kneeshaw and Van den Bergh (1989), and annual reports of various central banks).
Now consider the usefulness of foreign exchange swaps as a money market tool for less developed countries. The preceding discussion suggests that swaps could be recommended for countries that (i) wish to conduct monetary policy in a market-oriented way; (ii) target a monetary aggregate; (iii) lack a well-developed market for short-term securities (especially countries where there is no securitized government debt); and (iv) have deep spot and forward foreign exchange markets. The latter criterion is probably the most binding. Developing countries that do use foreign exchange swaps include Kuwait, Saudi Arabia, and Malaysia, all of which meet the forward market criterion,4 as well as Oman, United Arab Emirates, Bahrain, and Turkey, which do not.
The central bank of Saudi Arabia (SAMA) provides liquidity to banks through foreign exchange swaps using spot sales of U.S. dollars to itself with a repurchase agreement based on the market-determined forward exchange rate. The swap facility is not a very important instrument in terms of size, but it has been helpful occasionally—for instance, when swaps were used during the recent regional crisis to provide emergency liquidity to the market.
The Central Bank of Oman (CBO) started its swap facility in March 1980. All foreign exchange swaps (always expansionary) are initiated by the commercial banks, each with an individual ceiling. Initially, U.S. dollars were swapped at par (the Omani rial is pegged to the U.S. dollar, and the exchange rate has been very stable). This is, of course, related to the fact that there is no developed forward market in Omani rials, and the financial system is fairly regulated. The drawbacks of this situation became clear in 1986, when the domestic interest rate exceeded international rates. This gave the banks the possibility of risk-free windfall profits, leading to a peak level of RO 27 million outstanding in August 1986. In July 1986, the facility was modified to cure this flaw, and the oustanding swap amount subsequently declined sharply. In 1989, there was a squeeze on banks’ Omani rial liquidity, so the use of the swap facility peaked again, at RO 35 million in April 1989 (averaging 7.19 percent of reserve money for 1989). Apart from these peaks, the share of reserves acquired through foreign exchange swaps in the monetary base has been less than 1 percent. Another disadvantage of the lack of market-orientedness in Oman’s swap system is that the CBO cannot do reverse swaps to withdraw liquidity because they would cause destabilizing expectations of exchange rate movements. The system is not very flexible as a result.
In Turkey, monetary control has been exercised largely through the reserve requirement ratio and occasionally through limits on central bank credit. Beginning in 1987, open market operations have been expanded but are still limited by the size of the central bank’s portfolio and the thinness of the securities market. The Turkish lira–U.S. dollar swap facility has been in operation for more than a decade, and the swaps are carried out as an exchange of mutual deposits, which gives rise to the four-entry system mentioned earlier. The foreign exchange deposit causes the central bank’s foreign assets to rise and creates a (forward) foreign liability. The Turkish lira deposit increases banks’ reserves and the central bank’s domestic assets. During the term of the swap, the central bank’s foreign asset is valued at the historical exchange rate, but its foreign exchange liability is revalued with the current exchange rate. As the Turkish lira has been depreciating constantly since the 1970s, the net of these four items is always negative. This net figure is called “foreign exchange swaps” in the Turkish banking system accounts. The interest on the Turkish lira deposit, which should in theory compensate for the capital loss, goes into the profit and loss account.
This treatment implies that no forward exchange rate is agreed upon; the central bank relies on the uncovered interest parity to hold. The amount of swaps outstanding peaked in Turkey in 1988, probably because the anticipated liberalization of interest rates in October 1988 was expected to widen interest differentials substantially, thereby reducing the profitability of swap operations to commercial banks. The outstanding amount has decreased notably since then and has been virtually stable since mid-1990, when the central bank stopped actively using swaps.
III. Management and Acquisition of Foreign Exchange Reserves
Swaps are also used as a tool for the management and acquisition of foreign exchange reserves, with both the banking system and other central banks acting as counterparty. Such use sometimes coincides with the use of swaps to stimulate the domestic financial system.
Central banks nowadays are under more pressure to actively manage their assets than in the past; besides defending the exchange rate, they have to search for better returns as well. But, since intervention in the foreign exchange market requires instant access to reserves, liquidity is crucial. In determining the currency composition of their reserves, some central banks take account of the currency composition of their country’s import basket, with higher weights for currencies with liquid bond markets and for currencies that a country uses for intervention. This provides a rationale to use currency swaps to temporarily adjust the currency distribution when it has been distorted as a result of intervention. The central bank of Norway uses currency swaps and forwards to maintain the liquidity of its assets while leaving the currency distribution unchanged.
Currency swaps also provide cross-currency hedging (and interest rate hedging if cross-currency interest rate swaps are used). This is done when the foreign assets are denominated in different currencies than the foreign liabilities. In less developed countries, foreign asset-liability management is not so much about maximizing returns while maintaining liquidity as it is a matter of minimizing the inevitable financial risk. One way to do that is to improve the matching and currency composition of foreign asset and liability structures. A developing country that has engaged in such activities is Trinidad and Tobago. The country has considerable external debt, denominated in Japanese yen, which was partially taken over by the central bank. The widely fluctuating foreign reserves (mainly earnings from oil exports) are largely in U.S. dollars, since the TT dollar is pegged to the U.S. dollar. The central bank has used currency swaps to hedge against changes in the U.S. dollar-yen exchange rate, as well as swaps from floating-rate into fixed-rate liabilities.
Another rationale for using currency swaps in asset-liability management is to influence published official foreign exchange asset positions— that is, hide the real fluctuations in them. The Banque de France has reportedly done this, and many others may also be doing so quietly, since it is unlikely to be public knowledge.
Acquisition of Foreign Exchange Through Swaps Among Central Banks
In addition to commercial banks, other central banks can also act as a counterparty in foreign exchange swap transactions. If central banks deem it necessary to intervene heavily in the foreign exchange market, they may acquire the needed reserves by drawing on a swap line with another central bank. It is for this purpose that the Federal Reserve’s swap network exists: a system of reciprocal short-term credit arrangements between the Fed and 14 other central banks (those of most western European countries, plus Canada, Mexico, and Japan) and the Bank for International Settlements. The network enables the Fed to acquire currencies needed to counter disorderly market conditions through market operations, and it enables the swap partners to acquire the dollars they need to conduct their own operations. The Fed’s swap lines amount to $30.1 billion.
Swap drawings to finance official exchange intervention do not affect the money supply under these operating procedures. For example, if the Fed draws on the swap line with the Bundesbank, the Bundesbank, which does not immediately need the dollars, invests them in U.S. securities so that these dollars find their way back into U.S. bank reserves (Kubarych (1978), p. 19). These Federal Reserve swaps were prominent in the late 1970s but their importance has diminished since then (although the swap lines have increased). Swaps between central banks do not arise for foreign exchange intervention purposes exclusively; they can also be connected with trade. For example, Guatemala and Costa Rica swapped their currencies in the early 1980s to deal with regional trade deficits.
Acquisition of Foreign Exchange Reserves in Situations of Scarcity
Many developing countries suffer from substantial external indebtedness and wide fluctuations in their export earnings, as well as steady demand for imported basic goods. These countries must hold foreign exchange reserves in order to prevent excessive short-term fluctuations in the exchange rate, and liquidity is of prime importance. When faced with an acute shortage of liquid foreign exchange reserves, central banks in a number of countries have resorted to swaps to increase their gross foreign exchange holdings. Examples are Chile, Argentina, Uruguay, Ecuador, the Philippines, Indonesia, and the Republic of Korea.
Argentina experienced a balance of payments crisis starting in 1982, whereupon it announced a number of far-reaching measures to deal with the situation. They included foreign exchange swaps with domestic banks and residents in possession of foreign exchange deposits (such as importers). Also, domestic banks and corporations with foreign debt were encouraged to renegotiate the debts; the central bank of Argentina (BCRA) rewarded the renegotiation with what amounted to an exchange rate guarantee for the remaining life of the debt. Both measures exposed the BCRA to exchange rate risk; without cover, it was dependent on the uncovered interest parity to hold. The BCRA could not set its swap rate in this way, because it had to set a preferential rate to attract the swaps and because the announcement effect of a “realistic” swap rate would cause undesirable capital movements. Consequently, the BCRA suffered huge losses, with negative external operating results averaging about 0.5 percent of GDP since 1984. Other countries where central bank foreign exchange swaps have led to large losses from the depreciation of the domestic currency are the Philippines and South Africa.
Korea’s financial sector has been quite regulated. Before 1986, Korea had a persistent balance of payments deficit, so foreign exchange reserves were scarce. The central bank of Korea engaged in swaps with foreign commercial banks, which were not allowed to establish a network of local branches. This caused the domestic currency funding to be very limited, and to acquire working capital the banks borrowed from their head offices and swapped the proceeds into Korean won. The swap rate was chosen to provide an incentive for capital inflows, and individual bank swap limits were regularly increased. The larger part of these swaps was sterilized. As of 1986, the balance of payments went into surplus, which eliminated the need for swaps. The local branches of foreign banks were granted the option of having access to the discount window of the Bank of Korea and were allowed to issue certificates of deposit. The swap limits have not since been increased.
To sum up, the use of foreign exchange swaps in a situation of scarce foreign reserves has the advantage of providing a short-term capital inflow. However, they also have an expansionary monetary effect that has to be sterilized; if there is no (active) forward market, the central bank has to set a swap rate that may cause adverse signaling effects. Moreover, if the country is in severe crisis, using swaps to temporarily boost gross foreign exchange reserves will only delay the necessary adjustment.
Above all, if the central bank cannot keep its position covered (as in times of speculation against the currency), it is liable to suffer exchange losses. In the case of Argentina, these negative effects clearly outweighed the benefit. There are examples of other countries (such as Korea), however, that did not experience particularly adverse effects.5
The use of foreign exchange swaps to gain reserves is difficult to distinguish from swaps used to stimulate financial markets or to subsidize certain activities when the central bank acts as a market-maker in forward foreign exchange markets, provides forward cover and exchange rate guarantees, or subsidizes domestic financial institutions. Such activities have been common in developing countries. Regardless of the purpose, these operations are very similar to those discussed above; they amount to the central bank taking an open position, thereby assuming an exchange rate risk that often results in large losses. These kinds of activities are therefore not recommended, since central banks can do more to stimulate financial markets by conducting a credible exchange rate policy. Subsidies should be on the government budget, and the financial sector does not gain in the long run if its central bank incurs substantial losses.
Central bank losses negatively affect the economy in a number of ways. Large losses erode the central bank’s capital, which may jeopardize its independence. Moreover, the losses represent an injection of liquidity, which might make it necessary for the central bank to issue interest-bearing liabilities. This policy embodies a risk that future losses may grow exponentially. Persistent losses may also create pressure to implement an expansionary policy as a way to reduce future losses (Vaez-Zadeh (1991)).
IV. Summary and Conclusions
Central banks of industrial countries use foreign exchange swaps to “fine-tune” the money market, to acquire foreign reserves for intervention purposes, and to manage their assets and liabilities. In some developing countries, central banks also use foreign exchange swaps to control bank liquidity. In other cases, they use swaps to defend scarce official reserves and to stimulate or subsidize the domestic financial system.
As a money market tool, foreign exchange swaps are flexible and can be used in the absence of a well-developed short-term financial market. The operations should be conducted in accordance with market mechanisms; therefore, a deep forward foreign exchange market is necessary for the instrument to function smoothly.
As a means of defending foreign reserves in times of balance of payments problems, the appropriateness of foreign exchange swaps is considerably more questionable. In countries where these problems are acute, swaps can have adverse effects, because they leave the central bank with an open currency position that almost always creates losses. For the same reason, using central bank swaps to stimulate the development of financial markets is not recommended. Central bank losses could seriously damage monetary policy, and thus monetary stability. In countries with moderate and temporary balance of payments difficulties, swap schemes can be useful.
On a global scale, it appears that central bank foreign exchange swaps are losing favor; most swap facilities have been restricted or dormant in recent years. This is probably connected with the ongoing development of financial markets around the world. As short-term securities markets develop, swaps become less attractive as a money market tool, and the poor experiences of countries that have used swaps during difficult times have further discouraged their use.
DeutscheBundesbankThe Deutsche Bundesbank: Its Monetary Policy Instruments and Functions Special Series No. 73rd edition (Bonn: Deutsche Bundesbank1989).
HooymanC. J.The Use of Foreign Exchange Swaps by Central Banks: A Survey,IMF Working Paper 93/64 (Washington: International Monetary Fund1993).
International Monetary FundA Guide to Money and Banking Statistics in International Financial Statistics (Washington: International Monetary Fund1984).
KneeshawJ. T. and P.Van den BerghChanges in Central Bank Money Market Operating Procedures in the 1980s (Basle: Bank for International Settlements1989).
KubarychR. M.“Monetary Effects of Federal Reserve Swaps,”Federal Reserve Bank of New York Quarterly Review (Winter1977–78) pp. 19–21.
According to the uncovered interest parity, the forward rate is equal to the expected future spot rate. Thus, if the central bank, which is supposed to defend the currency, would set the domestic currency at a forward discount, this would have a strong announcement effect on the spot foreign exchange market.
Swaps can be seen as analytically similar to temporary operations in domestic securities: the exchange rate will normally be influenced only to the extent of the swaps’ impact on interest rates. Of course, this may amount to the same thing, as interest rate policy and exchange rate policy are often inextricably connected.
Here one must abstract from the possibility that the central bank ends up with a net short position in foreign currency, since in such situations central banks would not be using swaps as a money market tool.
South Africa also qualifies, and it does use swaps, but not as a money market tool.
Another way to obtain liquid foreign resources is through gold swaps; loans in foreign currency backed by deposits of gold. The classic operation consists of selling gold at the current price and repurchasing the same gold at a future date. Such an operation makes it possible to obtain temporary financing while paying an interest rate below the current market rate (the risk premium is reduced because the gold serves as collateral). Uruguay and Ecuador have been active in gold swaps, swapping gold for Swiss francs. As long as the central banks keep their positions covered (hold on to the foreign exchange to make sure they have a matching asset by the time the swap matures), there is no exchange risk involved. Unfortunately, when reserves are scarce this is often neglected, so that the bank will suffer a loss if the domestic currency depreciates during the swap interval.