Sino / Nigerian currency deals: Too soon to make a call

 Swap mechanics and technical details

Over the last 5-8 years, authorities held numerous discussions about the management of Nigeria’s international reserves and possibilities for further diversifying these predominantly US Dollar holdings into other currencies that hold particular strategic promise.  Eventually, in 2011, the CBN decided to start by switching less than 5% of its foreign reserves into China’s Renminbi. China, with its fast-growing industrial prowess, had become the second largest economy on the planet and a strong trading partner to nations around the world, including Nigeria.  Government statisticians at the NBS report that Nigeria imported more from China than any other nation then, and continues to do so now.  China is Nigeria’s largest trading partner, followed by the US, various EU countries, Brazil and India. 15% of Nigerian imports were Chinese in 2011. Last year, despite local payment difficulties and reduced capacities, 30% of Nigerian imports originated in China (i.e., approximately N 1.6 Trillion).

 Local and international reports of recently proposed currency swap agreements between the CBN and the Industrial and Commercial Bank of China (ICBC) likely confused the man on the street. Perhaps because top officials on both sides reporting the development were poorly briefed (on market practices, swap terms and operations), there now appear to be rising misconceptions around the sketchy details provided so far.  Swaps are arcane, financial products that remain practically invisible to all but active participants in this $2-plus trillion-a-day global market.  So what exactly is all this about?  What for and why is this necessary? This article (and perhaps others to follow) will try to explain plainly.

 This is about borrowing money. To be precise, Renminbi.  Why? To support Nigeria’s import needs from China.  This is now necessary because Nigeria needs credit to gain the breathing room required to adjust to pay cuts inflicted on its economy by the collapse in oil prices.  Plainly and squarely put, investments in infrastructure and the longed-for productivity that the country hopes to embark upon risk becoming monstrous white elephants if Nigerian industries lack the working capital boost needed to keep factories humming and workers employed.  For the moment, and given a motivated counterparty, swaps are the fastest-disbursing, foreign currency borrowing instrument available to the federal government. Others will follow but until then, and in order to keep trade facilities open, Nigeria’s foreign bills must be brought current.  Otherwise, the country’s risks damaging its reputation and relations with vital trading partners.

 A currency swap is, in essence, a financial arrangement whereby two parties agree to lend each other equivalent amounts of money in different currencies. It follows that the parties also agree to pay each other interest on the currency amount each receives.

 Central Bank liquidity swaps

 A Central bank liquidity swap is a type of currency swap used by a country’s central bank to provide liquidity of its currency to another country’s central bank.

 Since the financial crisis originating 2007/2008, central banks around the world have entered into a multitude of bilateral currency swap agreements with one another. These agreements allow a central bank in one country to exchange currency, usually its domestic currency, for a certain amount of foreign currency. The recipient central bank can then lend this foreign currency on to its domestic banks, on its own terms and at its own risk.

 Such arrangements were used by the US Federal Reserve Bank in the 2008 global financial crisis. In these foreign exchange deals, the Fed and the central bank of another major economy agreed to exchange their national currencies at the prevailing market exchange rate and simultaneously agreed to reverse the transactions at the prevailing forward market exchange rate on a specified future delivery date. The stated goal of these central bank liquidity swaps was to “to provide liquidity in U.S. dollars to overseas markets.”

 Although central bank liquidity swaps and forex currency swaps are structurally identical, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps instead represent emergency loans of U.S. Dollars to foreign markets via their respective central banks.

 In the context of the proposed Yuan swap deal, a Central Bank liquidity swap could work as follows;

The swap basically involves two transactions. When the Chinese central bank draws on its swap line with the CBN, it sells a specified amount of its currency (Yuan) to the CBN in exchange for Naira at the prevailing market exchange rate. The CBN would typically hold the Yuan in an account at with the Chinese central bank. The Naira that the CBN provides will be deposited in an account maintained by the Chinese Central Bank at the CBN.

 Simultaneously the CBN and the Chinese central bank will enter into a binding contractual agreement for a second transaction that obligates the Chinese central bank to buy back its currency on a specified future date at the same exchange rate.

 The second transaction unwinds the first. At the conclusion of the second transaction, the foreign central bank pays interest, at a market-based rate, to the CBN.

 When the Chinese central bank lends the Naira it obtained by drawing on its swap line to institutions in its jurisdiction, (probably those executing the various projects identified in Nigeria) the Naira is transferred from the Chinse central bank’s account at the CBN to the account of the bank that the borrowing institution uses to clear its Naira transactions.

 The Chinese central bank remains obligated to return the Naira to the CBN under the terms of the agreement, and the CBN is not counterparty to the loan extended by the Chinese central bank. The Chinese central bank bears the credit risk associated with the loans it makes to institutions in its jurisdiction.

 However, there has been no mention of this deal being consummated with the Chinese Central Bank (Peoples Bank of China – PBOC). What has been reported in the press is that the CBN signed a deal on Yuan transactions with the Industrial and Commercial Bank of China (ICBC), as a means of resuscitating the current currency slump in Nigeria.

 Critical elements in a swap transaction

In the first instance, there was only an announcement of the proposed swap deal, with the Industrial and Commercial Bank of China (ICBC) within the context of other deals supposedly signed on yuan transactions with the country.  The announcement lacks critical details about the key terms of the yuan swap deal such as: the exact nature of the proposed swap framework with China; the exact amount proposed under the swap deal; whether the deal amounts to a Central Bank liquidity swap deal; the tenure of the deal; the pricing of the deal and the exchange rate benchmarks used as parameters for the deal.

• To be continued tomorrow

 

Funso Sobande and John Oshilaja