The national bank of Ethiopia (NBE) and its counterpart central bank in the United Arab Emirates (CBUAE) have inked a swap and memorandum of understanding, according to a public announcement made last Tuesday. According to the NBE announcement, cross-border transaction settlement in local currencies would be possible up to a nominal value of 3 billion AED and 46 billion ETB ($795.8) at the current exchange rate.
In order to set an example and spur development for sustained foreign exchange surges in the nation, NBE is adopting a proactive and forward-thinking strategy. Its action is an illustration of brilliant strategy that, despite modest beginnings, may catalyze change and act as a ray of hope for a brighter future.
When the central banks of Ethiopia and the United Arab Emirates exchange their national currencies for a predetermined amount of time that isn’t specified on the public notice, this is referred to as a bilateral arrangement known as a currency swap agreement. The two nations’ central banks are expected to exchange predetermined amounts of their local currencies at the going market rate as part of the agreement; however, the rate at which the currencies are switched is pre-agreed and fixed for the period of the swap.
The main goal of a swap agreement is to give participating central banks access to each other’s currencies, enhancing liquidity and enabling them to meet short-term foreign exchange requirements. Swap agreements typically have a defined maturity date, after which the original currencies are exchanged back at the same pre-agreed rate.
This currency swap agreement enhances financial stability by providing a backstop against currency fluctuations, facilitating trade and investment, reducing dependence on third-party reserve currencies such as the US dollar, and building stronger economic ties. Central banks use currency swap lines to manage exchange rate risks and promote financial stability.
Similar agreements have existed between and among several economies and nations. The 2018 swap agreement between China-Japan is the biggest one with 200 billion Yuan (about $30 billion) with the aim to promote bilateral trade, direct investment, and financial stability between China and Japan. The three-year agreement, extended multiple times, has facilitated trade, reduced US dollar intermediation, enhanced financial stability, and strengthened economic ties by allowing central banks to use the swap line for liquidity support.
There are further instances of fruitful currency exchange arrangements with emerging nations. Currency swap agreements, such as those between China and Argentina, India and Japan bilaterally, Malaysia and China, and Indonesia and China, show how developing nations have effectively used these agreements to improve financial stability, encourage trade and investment, and lessen their reliance on major international currencies like the US dollar.
The 2009, the China and Argentina’s central bank’s agreement established a 70 billion Yuan currency swap line, reducing Argentina’s reliance on the US dollar and promoting trade and investment for the later during the times of economic and financial stress. Similarly Bank Negara Malaysia and the People Bank of China established a 180 billion Yuan currency swap line in 2015, promoting economic linkages and reducing reliance on the US dollar in Malaysia-China Currency Swap Agreement.
Trade-offs: implications of the Swap Agreement for the economic stability and stakeholder interests
It’s crucial to remember that the trade and investment policies between the two nations are not specifically governed by or restricted by the currency exchange agreements. These would be subject to current regulatory frameworks, trade agreements, and investment treaties, regardless of the swap line arrangements. This swap agreement is primarily focused on improving financial stability and liquidity, rather than imposing any specific restrictions on the economic activities between the participating countries. The indirect impacts on trade and investment are more about facilitating and promoting these economic linkages.
Some indirect implications for trade and investment flows between Ethiopia and UAE includes enhancing economic ties between countries by promoting cooperation, interdependence, and increased trade and investment flows. The swap line enables businesses and investors to effectively manage foreign exchange risks during trade and investment activities between two countries and improve efficiency and cost-effectiveness in bilateral trade and investment by reducing dependency on third-party currencies like the US dollar.
Swap lines facilitate trade settlements by providing mutual currency access, promoting bilateral trade through UAESWITCH and ETSWITCH platforms, thereby enhancing efficiency and effectiveness. The main question of this agreement is how these two central banks settle the exchange rate difference and volume. Albeit the fact that the statement does not explicitly stated, formal currency swap agreement between central banks outlines specific settlement mechanics and operational details, ensuring a transparent and smooth exchange rate and volume management process.
Experiences from other countries that are discussed in the aforementioned indicate that central banks of the involved countries pre-determine the exchange rate at which the currencies will be exchanged when the swap is initiated and when it matures. This exchange rate is fixed for the duration of the swap agreement providing certainty to both parties. Both central banks may periodically adjust exchange rates in line with market conditions to maintain the swap arrangement’s alignment with market conditions throughout its lifetime. The other crucial issue revolves around exchange rate differences between central banks. The spread is settled after swap maturation, with one bank paying the other (NBE to CBUAE) since the bilateral trade volume between the two shows deficit for Ethiopia to square off the transaction if the market rate moves favourably. As far as volume and liquidity management is concerned, both central banks agree on the maximum swap size or volume that can be activated under the arrangement. During the lifetime of the swap, either central bank can draw on the available liquidity by activating a portion of the total swap line. And there is no information about collateral and margin requirements if any at maturity which is usually part of the agreement.
What lesson can be drawn from pervious similar arrangements?
Scholarly research evaluates currency swap agreements’ effectiveness in promoting financial stability, facilitating trade and investment, and enhancing international policy coordination through empirical analyses. A few examples to mention are a study by Mengheng Li, Yongfu Huang, examines the effectiveness of Chiang Mai Initiative Multilateralization (CMIM) swap agreements among Asian countries, revealing their ability to reduce exchange rate volatility, improve financial stability, and facilitate increased trade and investment. Similarly, the roles of currency swap agreements in international monetary policy coordination and macroeconomic stability, found out that they enhance policy coordination and information-sharing among central banks during market turbulence according to Rasmus Fatum and James Yetman. Regarding influence of bilateral currency swap agreements on liquidity, Menzie Chinn and Hiro Ito indicated in their study that, they enhance foreign currency liquidity availability during financial stress and reduce US dollar liquidity demand.
Reducing inflation and focusing on policy space to stabilize macroeconomic variables in the economy are two of NBE’s key initiatives. Therefore, a quick discussion of this arrangement in relation to studies that assess the effects of currency swap agreements between nations on inflation and macroeconomic stability is warranted at this point.
The study by Giancarlo Corsetti et al. found that central bank currency swap agreements stabilize domestic inflation and output, mitigating financial shocks. On the same token, Cedric Tille’s study found that these agreements reduce exchange rate pass-through, improving monetary policy effectiveness. And Marcos Chamon et al.’s study highlighted the importance of these agreements in liquidity and macroeconomic stability.
These academic research studies offer evidence on the role of currency swap agreements in influencing inflation dynamics and contributing to macroeconomic stability, particularly in developing market economies. Swap agreements offer a more flexible and market-based approach to managing liquidity, allowing central banks to maintain open capital accounts while accessing foreign currency funding when needed. Overall, swap agreements are a powerful tool for central banks to manage inflation and promote macroeconomic stability.
Trade relationship between the two economies
The analysis of the import and export data for goods from the United Nations Conference on Trade and Development (UNCTAD) for the last ten years (2014–2023), although missing data for services import and export, reveals a significant discrepancy in bilateral trade between the two. According to the graph, net imports during the reported period were twice as high as exports to the United Arab Emirates.
This necessitates using extreme caution when dealing with the agreement, which is highly anticipated to resolve the immediate/short run mayhem our economy is facing with regard to foreign exchange reserves and dependence on major currencies. Immediate impact involves around exchange rate risks in swap agreements where significant consequences for less developed, poor country and net importer like us. These countries often bear the brunt of the risk, as their local currency depreciates against the trading partner, relatively developed country’s currency. This can lead to substantial losses when repaying the swap at a higher exchange rate. The strain on foreign exchange reserves can also strain the poorer country’s limited reserves, potentially undermining the swap agreement’s intended purpose. Additionally, the loss of policy autonomy can lead to restrictive monetary and fiscal policies, limiting the country’s ability to pursue economic development. Furthermore, the negative experiences can make the poorer country hesitant to enter future swap agreements, even during economic turmoil.
Other countries agreements previously indicates on currency swap agreements involving net importers, weak currency holders and poor countries has revealed several key lessons. These include power imbalances, moral hazards, geopolitical implications, limited effectiveness in crisis situations, and transparency and accountability challenges. Research shows that weaker countries often have less bargaining power, leading to disproportionate risk and costs. Additionally, swap agreements may introduce moral hazard concerns, limiting policy autonomy and undermining domestic financial resilience. Geopolitical implications can create concerns for weaker countries about the potential politicization of swap arrangements. Transparency and accountability are crucial for developing countries, especially those with limited bargaining power. Therefore, it is essential for these countries to carefully evaluate potential risks and negotiate more favourable terms.
