Currency Swap: No Silver Bullet but Necessary Pain Killer

Foreign currency shortage forced the government to take measures, such as the devaluation of the Birr against a basket of major currencies, it otherwise would not. While long-term solutions are being hashed out, it is crucial to look at currency swaps as short to middle term fixes, writes Amanuel Assefa (, a finance and risk professional with over fourteen years of experience in the financial services industry. 

The announced privatisation of major state enterprises, developments in the cross-border economic integration and strategic investment by the United Arab Emirates (UAE) are partiy, if not significant, efforts to address the depletion of foreign exchange reserves. Perhaps one other avenue that needs further exploration is entering into a cross currency swap with strategic and key trading partners.

This is similar to the announced currency swap between Ethiopia and Sudan in late 2017, which makes the respective countries’ currencies available to each others’ local banks. This is barely a revolutionary concept, central banks around the world have extensively used currency swaps to boost reserves and lend foreign currency to local banks and corporations.

The Central Bank of Nigeria just recently executed a three-year swap with China for 2.4 billion dollars equivalent facilitating availability of the Chinese Renminbi to Nigerian businesses and the Nigerian Naira to Chinese investors looking to invest in Nigeria. It was in itself an interesting transaction as a testament to the renminbi’s rising importance as a potential reserve currency and continued significance of China as a trading partner.

A currency swap is an avenue that Ethiopia can take advantage of in the short to medium terms. But the nation can also leverage it as a complementary tool in the long-term alongside its more strategic initiatives to lead to a positive balance of payments.

A currency swap is an exchange of a principal amount and interest in one currency for the principal and interest amount of another currency. The principal amount is exchanged at inception and interest payments are made on a periodic basis, typically on semi-annual ones.

The currency swap can be implemented in several ways – such as exchanging the principal amount at inception, having the interest rate be fixed-for-fixed, floating-for-floating or fixed-for-floating. The principal amount exchanged is reversed at the end of the term of the transaction – the local bank gets its local currency back and pays the foreign currency.

Since there is a direct need for foreign currency in Ethiopia, the exchange of the principal amount at inception of the agreement with semi-annual fixed periodic interest rate payments upfront would be the most plausible structure of the swap.

The ideal counterparts to the currency swap will be countries that Ethiopia has the most capital inflow from and, at the same time, countries that provide Ethiopia’s top imports.

The top ten foreign direct investments (FDI) into Ethiopia between 1992 and 2017 are from China, India, the United States, Sudan, United Kingdom, Saudi Arabia, Turkey, Netherlands, Italy and Canada. The top three nations constitute more than 36pc of the entire FDI inflow to Ethiopia, according to Asoko Insight, an integrated Africa-focused market research platform.

In addition to FDI, another significant source of income into the country is remittances. Remittance inflow into Ethiopia has averaged just over a billion dollars annually from 2012 to 2016, peaking at 1.8 billion dollars in 2014 and falling to 772 million dollars in 2016, according to the World Bank.

Remittances from Saudi Arabia stands at about 191 million dollars, which stands second to the approximately 255 million dollars annual remittances from the United States. Given that Ethiopian migrant workers in Saudi Arabia transfer most of their earnings back to their home country, there will be a need to convert Saudi Riyals into Birr.

Similarly, as Saudi Arabia is one of the top 10 countries that Ethiopia imports from, the local importers will need Saudi Riyals to pay for imported goods.

On the outflow side, the World Bank data suggests that Ethiopia’s imports from China make up for about a third of the entire amount. The Asian country is followed by the United States, India, Japan, Italy, Turkey, Kuwait, Saudi Arabia, Malaysia and Morocco. These 10 countries constitute over 72pc of Ethiopia’s imports.

Ethiopia’s top imports in addition to food products are primarily capital goods – such as industrial and electrical machinery, motor vehicles and parts, steel as well as petroleum and fuel products.

The top three FDI participants and top three countries that Ethiopia imports from are China, India and the United States. Entering into a three to five-year currency swap with each of these three countries denominated in their respective currencies against the Birr will have a meaningful impact towards managing the foreign currency shortage.

It will help provide access and liquidity to Ethiopian importers buying goods from these three countries. And Ethiopian importers will take advantage of readily available Chinese Renminbi, dollars or Rupees for their importing needs. These top FDI participants in Ethiopia can also readily access Birr from their national banks as they seek to make direct investments into Ethiopia.

From a numbers perspective entering into a currency swap is a zero-sum game. The Birr reserves of the National Bank of Ethiopia (NBE), upon entering into a swap, will be reduced by equivalent amount of increase in the reserves of that foreign currency.

Ethiopia’s long-term credit rating is also below investment grade, presenting a problem. The United States, China, Saudi Arabia and India all have an investment grade rating, meaning that those countries will require collateral to mitigate the potential credit risk of the NBE under a swap agreement. Such transactions inherently have exchange rate risk and interest rate risk that need to be accounted for.

There is also the concern that when the swap transaction matures, the NBE may not have the forex reserve to return the principal amount, though in practice the swap could be extended for another term. All these need to be acknowledged – risks mitigated and costs rationalised – before entering into such a transaction. Once there is a consensus that the benefits of entering into a swap far outweigh the challenges, risks and costs, the necessary steps should be taken to utilise financial instruments.

A cross-currency swap effectively exchanges a funding currency for another funding currency, which translates into a currency that can be issued as loans and deposits.

Having the NBE enter into several cross currency swaps will increase its liquidity in those specific currencies and NBE’s ability to extend credit to local importers and business people. And it will effectively reduce volatility risk to a single currency such as the dollar, and result in diversification of currency risks.

It will also allow a basket of currencies to effectively act as reserve currencies and also enable letters of credit to be issued in multiple currencies.  There will be no difference in how letters of credit are issued on behalf of local importers and business owners.

What is different here is how the NBE is sourcing its foreign currency. The bank that has a relationship with the importer will open a letter of credit on behalf of the importer as it usually would to guarantee the seller or the exporter on the side gets paid. Shortage of foreign currency and imports will no longer impede the ability of the local importer.

The allocation of limited foreign currency should be judicious such that it is prioritised for the importation of capital goods, petroleum products and essential food items that cannot be produced in the country.

A cross-currency swap is not the silver bullet that will address any foreign reserve deficiencies in the long-term. It is a mechanism by which the NBE can manage foreign currency liquidity for a period. Once the swap reaches maturity, the parties will need to exchange the currencies, if they choose not to extend or enter into a similar swap due to credit, market or political issues.

The goal is that the swap will provide a hard currency relief while export-oriented industries ramp up capacity and expand their export revenue. It is therefore critical that the maturity of the swaps in multiple currencies is spread out over time, otherwise it could result in deferring the very problem it is attempting to solve and could end up creating a more acute forex crisis down the road.

The intermediate interest payments in foreign currency will also need to be factored into the ongoing maintenance of the swap by being in compliance with timely interest payments. Depending on how the transaction is structured, some counter-parties may also require continuous collateral posting and the NBE should be in a position to meet the potential collateral requirements.

A currency swap does not just facilitate import and investment through the availability of currency. It promotes increased economic cooperation, lowered transaction costs as third-currency exchange risk is eliminated, and increased transaction volumes. It will also increase remittance amount as exchange risk to intermediary currency is eliminated associated with any fees charged to exchange into the intermediary currency.

The central bank can also open a letter of credit directly in the other currencies, and reduce volatility to the dollar. Executed the right way, this could go a long way in addressing the macroeconomic drag caused by the foreign currency shortage.

By Amanuel Assefa
Amanuel Assefa (, a finance and risk professional with over fourteen years of experience in the financial services industry. 

Published on Jul 14,2018 [ Vol 19 ,No 950]



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