Sri Lanka’s Currency Swaps Explained
The Central Bank of Sri Lanka (CBSL), on 28th June, said that it is expecting to obtain a currency swap of USD 250 million from Bangladesh along with another currency swap of USD 400 million from the Reserve Bank of India (RBI), in August this year as a short term remedy for foreign currency liquidity problems.
Previously, Sri Lanka has been largely relying on RBI to obtain currency swaps which were settled after six months. This is the first time Sri Lanka is obtaining a currency swap from Bangladesh, and according to reports, it is expected to be settled in three months with a potential extension up to six months.
What is a currency swap?
“Currency swap” refers to an arrangement of one entity obtaining a specific amount of a currency by providing a different currency to another institution. As the word “swap” implies, it refers to an exchange, except the exchange happens in currencies instead of goods. Currency swaps can take place between banks, financial institutions, central banks and companies.
Here’s how a currency swap happens: Assume that a currency swap agreement takes place between the central bank of country A which requires US Dollars and the central bank of country B which has sufficient US dollars. The central bank of country B provides 100 million USD to the central bank of country A in exchange of equivalent amount of domestic currency (such as Rupees) provided by the central bank of country A (100 million into the exchange rate of USD at the time). If we assume that the exchange rate is 50 rupees per one US Dollar, that means country A provides 5000 million rupees to country B in exchange of receiving 100 million USD. Two central banks agree to swap back the currencies along with the interest after a specific time, which mostly is 3-4 months. This is termed as the settlement of the currency swap.
Sri Lanka’s currency swaps
Currency swaps have been a frequent tool utilized by Sri Lankan banks as well as the CBSL to obtain US dollars. CBSL have been using currency swap agreements with central banks of other countries to obtain US dollars to boost foreign exchange reserves of the country. Since 2015, CBSL has entered into seven currency swap agreements with RBI and one agreement with the People’s Bank of China (PBoC). In the case of currency swaps with RBI, most were obtained under the Framework on Currency Swap Arrangement for SAARC countries. According to the framework, RBI, from its foreign currency reserves provides either US Dollars, Euro or Indian Rupees to another SARRC country in exchange of the equivalent to domestic currency. The swap is expected to be settled within three months, but with an option of extending it to period of six months. Under the Currency Swap Arrangement for SAARC countries, RBI has allocated USD 2,000 million to assist SAARC countries.
On four occasions, Sri Lanka had obtained 400 million US Dollar swaps from RBI under the SAARC currency swap facility, all of which were settled in six months. This means, in most cases, the swap was rolled over once the original agreed upon period of three months was concluded. In obtaining these currency swaps, Sri Lanka was required to provide an equivalent amount of Sri Lankan Rupees to India. However, in reality, the equivalent amount of Sri Lankan Rupees to USD 400 million was kept in a special non-interest-bearing account at the CBSL under the name of the RBI, and since the RBI did not use Sri Lankan Rupees, interest was not charged from RBI. CBSL however had paid interest to RBI at the point of settling the currency swap as Sri Lanka used the USD obtained. In addition to the SAARC currency facility, Sri Lanka has also obtained three swaps from RBI directly. In September 2015, the CBSL obtained a special US Dollar swap of 1,100 million and another 700 million in 2016 from RBI to manage foreign currency liquidity.
In addition to that, in 2014, Sri Lanka entered into a currency swap agreement with PBoC which provided an opportunity to exchange Sri Lankan Rupees with Chinese Yuan for trade related activities and other purposes agreed by both countries. However, this arrangement did not result in a currency inflow like the currency swaps with RBI. Instead, it was a standby arrangement under which Sri Lanka could pay for Chinese imports in Sri Lankan Rupees instead of Chinese Yuan. However, this standby swap facility was not used as Chinese imports are invoiced in US Dollars, thus requiring to payment in US Dollars.
Why do countries use currency swaps?
The simple reason to obtain a currency swap is to tackle foreign exchange shortfalls in the short term. Countries face foreign currency shortages when the foreign currency inflows from exports, Foreign Direct Investments (FDI) and workers remittances are not sufficient to pay for imports and repay foreign loan obligations, which are foreign currency outflows. Since the loans are obtained in US dollars, those must be paid back in dollars too. Therefore, countries also require dollars to repay foreign loans as well. The more loans to be paid, the more dollars required.
In order to provide US dollars to pay for imports and foreign loan repayments, each country’s Central Bank is required to maintain a substantial amount of foreign currency (mostly US Dollars) in reserve at any given time. The Central Bank provides US dollars to the government to repay foreign loans (and interest) and provides dollars to commercial banks to pay for the imports on behalf of importers, ensuring smooth functioning of the economy.
When a Central Bank does not have a sufficient amount of dollar reserves, it becomes difficult to import goods and pay foreign loan installments, which in turn adversely affects the functions of an economy. In such instances, currency swaps becomes an extremely useful instrument as it provides foreign currency (mostly US Dollars) to Central Banks in exchange of an equivalent amount of domestic currency. The Central Bank which faces a dollar shortage provides local currency (such as rupees) to another Central Bank in exchange of dollars. The obtained dollars are then used to pay for imports and repay foreign loans. After a few months, dollars are re-swapped for local currencies, settling the currency swaps.
Sri Lanka’s external sector problem
Sri Lanka has been using currency swaps frequently as the country has been grappling with a severe external resource financing gap during the last decade. In other words, Sri Lanka does not have sufficient foreign currency inflows (US dollars mainly) to match foreign currency outflows. Therefore, every year Sri Lanka is compelled to obtain foreign loans, or increase dollar inflows by other means. Currency swap is one such instrument that can only be used in the short term. Other options to increase foreign currency inflows included entering an Extended Fund Facility with the International Monetary Fund (IMF) in 2016 and leasing the Hambantota Port in 2017.
As illustrated by Graph 1, in the last decade, Sri Lanka has been grappling with severe BOP issues as the country had failed to increase export earnings substantially while the foreign loan payments had increased significantly. This means foreign currency inflows to Sri Lanka remain stagnant while foreign currency outflows have increased significantly, resulting in an expanding gap between foreign currency inflows and outflows. Successive governments were compelled to explore various methods to bridge this gap by increasing the foreign currency inflows.
Graph 1: Export ratio decline of Sri Lanka and increase of foreign debt repayments
Source: Author created based on CBSL data
Sri Lanka’s current foreign exchange crisis is a result of failure to increase exports and continuing to borrow from international capital markets through issuing International Sovereign Bond (ISBs). These ISBs have a high interest rate and a remarkably high capital repayment when it is repaid. Therefore, Sri Lanka’s external sector crisis cannot be resolved using currency swaps alone, and requires a long-term export growth and reduction in its reliance on foreign commercial borrowings (ISBs).
Swaps and future
Currency swaps are merely holding operations and only provides a short-term solution to manage foreign currency shortages. For this reason, currency swaps do not offer a solution to the economic issues that Sri Lanka has been grappling with. However, as the foreign currency shortage gets severe while having very little opportunity to borrow from international capital markets, coupled with the reluctancy to seek an IMF bailout support, the CBSL seeks to use currency swaps as a major tool to tackle foreign currency shortages.
Graph 2: Sri Lanka’s foreign currency reserves fell to USD 4 billion in April 2020 from USD 9 billion recorded 2 years ago
If all the planned US Dollar swaps are materialized within the coming months, it will provide foreign currency inflows to cover approximately 70% of foreign loan repayments during the three upcoming months. That indicates how heavily Sri Lanka is reliant on currency swaps. The issue is that these currency swaps should be settled in 3-6 months and that will result in a significant foreign currency outflow at the time of settlement. The CBSL will have to look for a significant amount of foreign currency to settle these swaps.
Sad reality, as illustrated in Graph 3, is that Sri Lanka will have to deal with foreign exchange shortages in upcoming years as the country is burdened with heavy foreign loan repayments largely due to the maturity of ISBs. As a result of that, Sri Lanka’s foreign currency outflows in upcoming years will remain high. On the other hand, increasing export revenue substantially is not feasible in the short term.
Graph 3: Upcoming foreign loan repayments of Sri Lanka
Source: External Resource Department
The COVID-19 hit tourism sector will take a few years to recover. Furthermore, due to the current macroeconomic conditions Sri Lanka is not able to borrow from international capital markets by issuing ISBs. This means Sri Lanka’s foreign currency inflow will remain stagnant, creating a dearth of foreign currency (mostly dollars). In the medium term, the country would be able to avoid foreign currency shortages by restructuring foreign debt and obtaining a bailout package from the IMF. Even then, Sri Lanka will have short term foreign currency shortages, indicating frequent use of currency swaps.
Currency swaps are a useful and important financial instrument to tackle a foreign currency shortage in the short term. But it is by no means a solution to the economic issues that Sri Lanka is struggling with. You can’t keep patching a tire. You will have to buy a new tire in the longer term. Sri Lanka needs to keep this analogy in mind when it resorts to use currency swaps.
Written by Umesh Moramudali