Swap line explainedThe central bank may act as a facilitator for currency swaps in the financial market
A temporary reciprocal currency arrangement between central banks is known as swap line. It is a bilateral agreement between central banks in which they promise to keep a supply of their respective country’s currency available to provide to another central bank at the going exchange rate. The purpose of a swap line is to keep liquidity in the currency available for central banks to lend to their banks to maintain their reserve requirements.
Major central banks around the world have bought $21 trillion in government debt globally since 2008, pushing investors to search for yields in riskier markets. Quantitative easing (QE) saved us from the 2008 crash and kick-started a recovery, but also encouraged a build-up of one-sided risk in the financial system. The result is a pyramid of trades dependent on stable interest rates: $12 trillion of government debt yields less than 1 percent, and the yield from $11 trillion of corporate debt is nearing a record low. As cash flows and growth rates are discounted at near zero rates, $8 trillion of high dividend and growth stocks trade at record high valuations. At the top of the pyramid are strategies betting on stable volatility and asset correlations, which total up to $2 trillion, according to estimates.
While the Federal Reserve is normalising policy rates, the European Central Bank (ECB) and Bank of Japan remain the fulcrum for central bank balance sheets making up half of global QE assets. This means it will be more difficult for them to exit without shocks. In turn, financial shocks can hurt growth, potentially through three contagion channels.
One, if QE worked through a wealth effect on asset prices and consumption, falling markets could reverse it. In the US, the top 10 percent of income earners account for a quarter of national consumer spending, according to the Bureau of Labour Statistics. This is also the group of people who saw their net wealth grow 24 percent from 2010-16, thanks to rising asset prices, while the bottom 40 percent of earners experienced a decline in net wealth in the same period.
Two, an easy monetary policy has reduced funding costs for corporates but also kept ‘zombie companies’ alive instead of having them restructured. This weak tail of corporates is susceptible to a sharp rise in bond yields: Default risks would increase materially if the five-year Treasury yield is near 3 percent and high-yield spreads are above 500 basis points (bp), according to UBS research. Three, tighter and more volatile financial conditions tend to discourage investments and dampen sales, which, in turn, hurt growth. As research by the St Louis Fed suggests, corporate investment in 1990-2015 on average dropped by more than 10 percent when financial conditions were bad, while sales growth also stagnated.
During the financial crisis following the collapse of Lehman Brothers in September 2008, markets dried up because of extreme risk aversion. It became very difficult for euro area banks to obtain US dollars to fund their USD-denominated assets. To prevent disruptions, such as banks having to sell assets abruptly, the ECB and the Federal Reserve entered into a currency swap line agreement, allowing the ECB/Euro system to provide US dollars to banks located in the euro area.
The swap arrangement
In the aftermath of the financial crisis, the ECB set up arrangements to provide euro to the central banks of Denmark, Latvia, Hungary, Poland and Sweden. The ECB established a currency swap agreement with China. The swap arrangement created liquidity in case of an emergency, making it safer for euro zone banks to do business in yuan instead of insisting on dollars or euros. The Reserve Bank of India signed a Special Currency Swap Agreement with the Central Bank of Sri Lanka in 2015.
Regulators in Nepal may think along similar lines for creating a swap line arrangement which will ease currency hedging for banks and financial institutions. Nepal Rastra Bank has provided borrowing facility to commercial banks of up to 25 percent of their core capital in convertible currency to lend to various infrastructure projects, except housing and real estate development.
A major roadblock to raising resources in convertible currency is the absence of a foreign exchange swap market. The central bank may act as a facilitator for currency swaps in the financial market. Swap lines may help Nepal to be less dependent on the International Monetary Fund (IMF). To build an anti-fragile market, regulators should encourage diversity and long-term incentives among investors besides promoting instruments that act as circuit breakers in a crisis. Central banks should be prepared for an avalanche at the sight of the slightest fissure.
Thakurta is the head of the treasury department of Nepal SBI Bank