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.
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Hooyman, C. J., The Use of Foreign Exchange Swaps by Central Banks: A Survey, IMF Working Paper 93/64 (Washington: International Monetary Fund, 1993).
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Kneeshaw, J. T., and P. Van den Bergh, Changes in Central Bank Money Market Operating Procedures in the 1980s (Basle: Bank for International Settlements, 1989).
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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.