What is a currency swap?
A currency swap is a foreign exchange transaction that involves the exchange of interest payments between or among participating parties. The terms and conditions are also based on the contract made between or among them. A currency swap determines the relative value of assets involved. These assets include the exchange rate value of each currency and the interest rate environment of countries involved.
Through a currency swap deal, companies doing business abroad can take advantage of more favorable loan rates in the local currency. For corporate entities, it is better to do a currency swap than to borrow money directly from its local banks. Foreign companies can benefit from a lower rate of financing than what they would get from the local market.
How does the swap work?
Parties who made a currency swap agreement will decide on whether to exchange the principal amounts of their currencies at the beginning of the transaction.
For example, Company A in China plans to expand its business in Europe. On the other hand, Company B in Europe wants to acquire a company in China. However, both A and B don’t have sufficient funding. To reduce costs, both companies can enter into a currency swap. In this situation, Company A borrows money in China and swap this to Company B. Likewise, company B will borrow money in Europe and swap it to Company A. In this way, both companies can avoid higher rates by borrowing a foreign currency.
When both companies enter a currency swap deal, the type of interest is also decided based on the contract. They will also decide on the maturity date upon which the companies will exchange back principal amounts. This refers to the money they have borrowed at the beginning of their transaction. They will also exchange interest payments according to what they have agreed upon.
2 types of interest rates
Fixed interest rate: It is the most favorable during periods of low-interest rates. It is also advisable for those who don’t want their interest to fluctuate over the terms of their loan contract. However, this type of interest is much higher than float interest.
Float interest rate: It is also referred to as variable interest. The rates can vary depending on the market and throughout the debt obligation. Nevertheless, it is usually much cheaper and credit card companies mostly carry out this type of interest. Float rates are adjustable rates as in mortgages where the monthly payment changes.
Types of currency swap contracts
- Fixed vs. float
- Float vs. float
- Fixed vs. fixed
Currency swap may be beneficial to companies in terms of reducing the cost of paying for a foreign currency rate. However, at the end of the day, it is up to the company’s strategy on whether it loses or gains from the agreement. Thus, companies involved in a currency swap deal must take into consideration the payments they will have to make at the end of their contracts.
Mutual benefits of currency swap
As China’s second-largest global trading partner, the EU stands to benefit from a more stable bilateral trade and investment with China. On the other hand, China sees the swap as a “backstop liquidity facility” and to make sure that it continues to provide Chinese currency yuan to euro area banks.
Furthermore, the currency swap deal between China and Europe may depend on a balance of investment. Both countries can gain from a currency depending on how much they want to invest. If Chinese companies are looking to invest twice as much as European companies, then it would turn out to be more favorable to Europe.
According to the People’s Bank of China (PBoC), the move to extend the currency swap deal with Europe through the ECB will provide liquidity support for the development of the renminbi market in Europe. Hence, it is intended to enhance the promotion of the renminbi for global use.
In 2016, the International Monetary Fund (IMF) added the Chinese renminbi to its Special Drawing Rights (SDR) basket. The SDR is an international reserve asset created to supplement the member countries’ official reserves. For China, the inclusion of RMB into the SDR has been a significant step towards liberalizing its financial economy as well as expanding its free trade with other countries. As of now, the Chinese renminbi has joined the rest of the currencies including the US dollar, the euro, the Japanese yen, and the British pound sterling.
With the internalization of RMB, the increased convertibility and tradability of the Chinese yuan become an investment advantage especially for private equity firms in China. Moreover, since the RMB is internationalized, companies can easily enter into a currency swap deal.
Therefore, countries involved in currency swap agreements are expecting to boost their trade agreements and economic developments.
Bilateral currency swap with other countries
The Chinese government is stepping up its RMB internalization policy with the currency swap arrangements. It has made bilateral swap deals with various countries since 2008 including South Korea, Singapore, Indonesia, India, Russia, and Nigeria.
In September 2013, China and the United Kingdom signed the first bilateral currency swap deal worth 200 billion yuan (21 billion pounds). Then, it also signed agreements with the European Union in the following month. The China-EU currency swap deal became China’s third-largest after its facilities with Hong Kong and South Korea.
The bilateral trade between China and the European Union has already resulted in USD337.99 billion worth of total trades. By 2020, both countries also expect to reach a more comprehensive EU-China investment deal. This investment agreement which began in 2013 aims to continuously provide open market access for both China and European countries.