Sri Lanka negotiating currency swaps with foreign central banks: CB Governor

Jan 06, 2009 (LBO) – Sri Lanka’s is negotiating with foreign central banks to establish swap arrangements to increase its access to foreign currency, central bank governor Nivard Cabraal said. The Central Bank said it was looking for alternative ways of raising external finance after hedge fund money that came into the Treasuries market left suddenly in the wake of global turmoil.

One method that was being explored was to enter into currency swap arrangements with some central banks on a bilateral basis, Governor Cabraal said, in his annual speech on monetary policy on January 02.

“Some central banks have already responded positively and the CBSL (Central Bank of Sri Lanka) is currently negotiating such arrangements,” Governor Cabraal said.

A standard currency swap involves the sale of one currency against another in the spot market, and an agreement to buy it back (reverse the transaction or buy forward) at a future date at the forward exchange rate.

In 2008 the US Federal Reserve opened swap lines to the European Central Bank and monetary authorities of England, Switzerland, Canada, Mexico, Brazil, Singapore and others valued at about 600 billion dollars, amid severe shortages of dollars worldwide.

Under such a deal also known as a reciprocal currency arrangement, the Fed gives (or sells), US dollars against the currency of the foreign central bank, but agrees to buy the dollars back at the same exchange rate (the spot and forward legs have the same rate).

Such transactions were done because many markets ran out of dollars as banks were left with ‘toxic’ US dollar assets which simply could not be sold, leading to very high inter bank dollar rates.

The foreign central banks could then advance the dollars from the swap to their own banking systems which were starved of US currency, usually on an overnight basis.

Central bank swaps are usually short term, typically 30 days to 3 months. The recent series of Fed swap lines are due to expire in January and April 2009. But they could be rolled over.

Governor Cabraal however said the Fed was not included in the central banks with which negotiations were now underway. He said Sri Lanka was looking for swaps that could last for up to three years.

Cabraal said the particular central banks involved would be made known later.

Sri Lanka has been losing reserves heavily since mid-September as the Central Bank went on a sterilized intervention campaign to defend a soft dollar peg, with predictable results. By end-October foreign reserves were down to 2,374 million dollars, against 3.4 billion dollars two months earlier.

Central bank swap arrangements are no longer generally used for intervention.

Floating rate central banks also no longer intervene in forex markets to strengthen their currency, but instead use policy rate hikes and open market operations to do so.

The Fed sometimes engages in co-ordinated interventions with the US Treasury mainly to signal its intentions to the market.

Other reserve currency central banks also intervene for signaling purposes, which however is not effective unless policy rates are also raised at the same time.

Any intervention is neutralized (or sterilized) through open market operations if policy rates are unchanged.

In the 1970s, after the collapse of the Bretton Woods agreement, and when central banks were groping in the dark with monetary policy after abandoning the last vestiges of the gold standard, Fed used swap lines to borrow foreign currency and intervene in forex markets.

In the 1960s when excessive US money printing was already putting the Bretton Woods agreement under severe strain, Fed also entered into swaps with foreign central banks which had acquired dollars and wanted to exchange them for gold.

To stop the outflow of gold, Fed borrowed foreign currency under a swap (and gave the foreign central bank a new set of dollars), then bought the original dollars off the foreign central bank with the foreign currency.

Foreign central banks agreed to such deals because the spot and the forward legs had the same exchange rate, and they were comforted that there would be no ‘depreciation’ of the dollar during the period of the swap.