It is argued – with high prospects of truth – that Africa’s economic transformation rests on making its countries predominantly exporting as opposed to importing economies. Exports, it is further argued, improve foreign currency reserves with which to pay for the indispensable imports like liquid fuels and gas, fertilizers, etc. Until African economies are able to export more than they need to import, foreign exchange reserves’ inadequacy remains a serious challenge. Central banks have the tough and often insurmountable task to keep conceiving ways for adequate foreign currency reserves. This article recommends central banks’ execution of cross-currency swap agreements.
To the uninitiated, a swap transaction is an agreement between parties to exchange sequences of cash flows for a set period of time. By extension, a cross-currency swap transaction entails exchanging one currency for another ie, for instance, the legal tender for Malawi [the Kwacha] for the United States Dollar.
In essence, a cross-currency swap is an over-the-counter agreement between two parties to exchange interest payments and principal denominated in two different currencies. The agreement between two parties is to exchange cash flows in different currencies at some predetermined interest rates for a specified period. It involves exchanging both the principal and interest payments in one currency for the principal and interest in another currency aimed at financing their needs.
Interest payments and principal in Kwacha are exchanged for principal and interest payments in United States Dollars. Interest payments are exchanged at fixed intervals during the life of the agreement. And since the two parties are exchanging amounts of money, the cross-currency swap is not required to be shown in their respective balance sheets.
- Key Characteristics of a typical Swap Transaction
A typical cross-currency swap transaction has the following characteristics: It is a bilateral agreement to exchange cash flows over a period of time. The agreement may involve an intermediary or a swap bank that brings the two parties together to complete the swap for a premium fee. The principal or notional amount is re-exchanged at the end of the period of the swap contract period. Payment intervals in swaps vary depending on the term structure of the swap agreement whether quarterly, bi-annually, or annually. As cross-currency swaps are off-balance sheet items hence they do not impact the balance sheet ratios, each party has the prerequisite advantage in meeting its own needs.
- Practical Demonstration
A predominantly importing country may be facing rapidly depleting foreign exchange reserves to levels that may bring the economy on its knees. Foreign exchange inflows might be waning in comparison to the needed amounts to pay for indispensable imports. For instance, there might be MK 3 billion [Malawi Kwacha Three Billion] [the Swap Amount] available for payment to a foreign-based supplier of LPG but no United States Dollars to remit the same.
The handiest, quick-fix solution for the central bank is swap transactions. The central bank identifies a counterparty in a foreign country. The counterparty has the United States Dollars. It is willing to exchange this for the Swap Amount for pre-agreed interest. The counterparty will usually identify a local bank [the Swap Bank] to be its agent for purposes of custody of the Swap Amount together with the pre-agreed interest on its behalf. The central bank will deposit the Swap Amount and the interest thereon with the Swap Bank. The counterparty will transfer the United States Dollars equivalent to the Swap Amount to the central bank. This makes available to the economy the much-needed foreign currency to pay for indispensable imports. The foreign supplier will thus be paid.
In Malawi, and indeed in other African countries alike, when well structured, a swap transaction might be beneficial to the central bank, the Swap bank, and a Government that relies heavily on domestic borrowing to finance its operations.
The central bank receives the much-needed foreign currency. Swap bank as recipient and custodian of the Swap Amount will have easily mobilized a huge deposit. The Swap Bank will then invest the Swap Amount in Government treasury bills. Everybody wins. In the end, the Central bank has the much-needed foreign currency. Swap Bank has the much-needed deposit. Government has the much-needed funds for its operations. Counterparty has the much-needed interest on the foreign currency. And Swap Bank has the much-needed return on investment from Government treasury bills. Structured this way, swap transactions are beneficial to all involved.
- Legislative Advantages of Swaps
Legislation in most African countries does not allow central banks to borrow from foreign banks or financial institutions without the authorization of the relevant Minister responsible for Finance. The Minister of Finance may hardly give that authorization without the approval of Parliament. Such a process is not devoid of red tape and bureaucracy. This is where swaps get handy. They are not a loan. They are not borrowing. They do not impact the balance sheet. They are over-the-counter transactions. As such, they may not require authorization from the relevant Minister of Finance. The central bank may simply require the resolution of its board to execute a swap agreement. The counterparty may simply require a confirmatory opinion of the Attorney General for it to be safe about the legality for the central bank to execute a swap. This cuts the red tape and bureaucracy that comes with borrowing or loans from foreign financial or other institutions.
A country without adequate foreign currency will fail to finance the importation of products and services that are indispensable for its people. Many ways for securing adequate foreign currency reserves may not be expeditious. For some countries, the legal frameworks for borrowing in foreign currency may be convoluted. As such, cross-currency swaps are certainly expedient ways for central banks to timeously shore up foreign currency reserves to meet indispensable imports and avert economic turmoil.