A Strategic Move For Economic Stability
The National Bank of Ethiopia (NBE) and the Central Bank of the United Arab Emirates (CBUAE) signed a currency swap agreement and a memorandum of understanding, according to a public announcement made last Tuesday. This agreement enables cross-border transactions in local currencies up to a nominal value of AED three billion and 46 billion birr (USD 795.8 million at the current exchange rate).
The NBE’s proactive strategy aims to set a precedent and stimulate sustained foreign exchange growth in Ethiopia. This strategic move, although modest in its initial scope, could catalyze significant economic changes and offer a beacon of hope for the country’s future.
A currency swap agreement, such as the one between the NBE and the CBUAE, involves the exchange of national currencies for a predetermined period. The central banks exchange set amounts of their local currencies at the prevailing market rate, with the exchange rate fixed for the duration of the swap.
The primary objective of a swap agreement is to provide the participating central banks with access to each other’s currencies, enhancing liquidity and meeting short-term foreign exchange needs. These agreements usually have a set maturity date, after which the original currencies are exchanged back at the same pre-agreed rate.
This currency swap agreement aims to enhance financial stability by mitigating currency fluctuations, facilitating trade and investment, reducing reliance on third-party reserve currencies like the US dollar, and strengthening economic ties between Ethiopia and the UAE. Central banks utilize swap lines to manage exchange rate risks and promote financial stability.
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Similar agreements have been established between various economies. For instance, the 2018 swap agreement between China and Japan, valued atYuan 200 billion (approximately USD 30 billion), aimed to promote bilateral trade, direct investment, and financial stability. This three-year agreement, extended multiple times, has facilitated trade, reduced US dollar intermediation, and strengthened economic ties by allowing central banks to use the swap line for liquidity support.
Other successful currency swap agreements include those between China and Argentina, India and Japan, Malaysia and China, and Indonesia and China. These agreements have helped developing nations improve financial stability, encourage trade and investment, and reduce their reliance on major international currencies.
The 2009 agreement between China and Argentina established a 70 billion Yuan currency swap line, promoting trade and investment during economic and financial stress. Similarly, in 2015, Bank Negara Malaysia and the People’s Bank of China established a 180 billion Yuan currency swap line, fostering economic linkages and reducing reliance on the US dollar.
Implications oneconomic stability and stakeholder interests
It’s crucial to note that currency exchange agreements do not specifically govern or restrict the trade and investment policies between the two nations. These policies remain subject to existing regulatory frameworks, trade agreements, and investment treaties.
The swap agreement primarily focuses on improving financial stability and liquidity, rather than imposing specific restrictions on economic activities between Ethiopia and the UAE. The agreement’s indirect impacts on trade and investment are more about facilitating and promoting these economic linkages.
Indirect implications for trade and investment flows between Ethiopia and the UAE include enhancing economic ties by promoting cooperation, interdependence, and increased trade and investment. The swap line allows businesses and investors to effectively manage foreign exchange risks during trade and investment activities, improving efficiency and cost-effectiveness by reducing dependency on third-party currencies.
Swap lines facilitate trade settlements by providing mutual currency access, promoting bilateral trade through platforms like UAESWITCH and ETSWITCH, thereby enhancing efficiency and effectiveness.
The main question regarding this agreement is how the two central banks will settle the exchange rate differences and volumes.
Although the statement does not explicitly address this, formal currency swap agreements between central banks typically outline specific settlement mechanics and operational details, ensuring a transparent and smooth process for managing exchange rates and volumes.
Experiences from other countries suggest that the involved central banks pre-determine the exchange rate at which currencies will be exchanged when the swap is initiated and when it matures. This exchange rate remains fixed for the duration of the swap agreement, providing certainty to both parties. Central banks may periodically adjust exchange rates in line with market conditions to maintain the swap arrangement’s alignment with the market throughout its term.
Another crucial issue involves exchange rate differences between central banks. The spread is settled after the swap matures, with one bank paying the other (NBE to CBUAE) to account for Ethiopia’s trade deficit. Both central banks agree on the maximum swap size or volume that can be activated under the arrangement. During the swap’s lifetime, either central bank can draw on the available liquidity by activating a portion of the total swap line. There is also no information about collateral and margin requirements at maturity, which is usually part of such agreements.
Lessons from previous arrangements
Scholarly research evaluates the effectiveness of currency swap agreements in promoting financial stability, facilitating trade and investment, and enhancing international policy coordination. For instance, a study by Mengheng Li and 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, RasmusFatum and James Yetman found that currency swap agreements enhance policy coordination and information-sharing among central banks during market turbulence. Menzie Chinn and Hiro Ito also indicated that these agreements enhance foreign currency liquidity availability during financial stress and reduce US dollar liquidity demand.
Reducing inflation and focusing on policy to stabilize macroeconomic variables are key initiatives of the NBE. Therefore, discussing this arrangement in relation to studies assessing the effects of currency swap agreements on inflation and macroeconomic stability is warranted.
A study by Giancarlo Corsetti et al. found that central bank currency swap agreements stabilize domestic inflation and output, mitigating financial shocks.
Cedric Tille’s study found that these agreements reduce exchange rate pass-through, improving monetary policy effectiveness. Marcos Chamon et al.’s study highlighted the importance of these agreements in liquidity and macroeconomic stability.
These studies provide 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 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 relations betweenthe two nations
An analysis of 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 Ethiopia and the UAE. According to the data, net imports during the reported period were twice as high as exports to the United Arab Emirates.
This necessitates extreme caution in dealing with the agreement, which is highly anticipated to address the immediate economic challenges related to foreign exchange reserves and dependence on major currencies.
The immediate impact revolves around exchange rate risks inherent in swap agreements, which can have significant consequences for less developed, poorer countries, and net importers like Ethiopia. Less developed countries often bear the brunt of the risk as their local currency depreciates against the more stable currency of their trading partner.
This depreciation can lead to substantial losses when repaying the swap at a higher exchange rate, further straining limited foreign exchange reserves and 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. Negative experiences with such agreements can make poorer countries hesitant to enter future swaps, even during economic turmoil.
Previous currency swap agreements involving net importers, weak currency holders, and poorer countries have 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, limit policy autonomy, and undermine domestic financial resilience. Geopolitical implications can create concerns about the potential politicization of swap arrangements. Transparency and accountability are crucial, especially for developing countries with limited bargaining power. Therefore, it is essential to carefully evaluate potential risks and negotiate more favorable terms.
Birhane Girmai is Certified Trade Finance Specialist (CTFS) working in the banking industry. He can be reached at: [email protected]
Contributed by Birhane Girmai
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