Bangladesh Bank (BB), the central bank of the country, has recently introduced a new system of currency swaps with commercial banks to rebuild its foreign exchange reserves. A currency swap is a transaction in which two parties exchange interest and principal payments in different currencies for a specified period of time. The swap allows the central bank to borrow foreign currencies from banks at a spot rate and return them at a forward rate with a swap point, which is determined by the interest rate differential between the two currencies.
Why did BB Introduce Currency Swap?
The main reason behind the introduction of currency swaps is to meet the net reserve condition set by the International Monetary Fund (IMF) under its $4.7 billion loan program for Bangladesh. The IMF requires Bangladesh to maintain a certain level of net international reserves (NIR), which is the difference between the gross foreign exchange reserves and the short-term foreign liabilities of the central bank.
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The BB has been facing challenges in increasing its reserves through the conventional method of buying US dollars from the interbank market, as the demand for the greenback has been high due to the rising import payments, debt servicing, and remittance outflows. The BB has also been reluctant to intervene in the market to avoid appreciation of the taka, which could hurt the export competitiveness of the country. Therefore, the BB has opted for an alternative way of raising its reserves without affecting the exchange rate, by borrowing foreign currencies from banks that have surplus dollars.
How does Currency Swap Work?
The BB has issued a guideline for currency swaps with commercial banks, which came into effect on February 15, 2024. According to the guideline, the BB will sell taka to banks in exchange for approved foreign currencies, such as the US dollar, euro, pound sterling, yen, and yuan, at the spot rate at the near-leg of the swap. The spot rate will be the interbank reference rate, which is currently Tk 110 per dollar. The BB will then buy back the same amount of foreign currencies from banks at the far-leg of the swap, by applying the same exchange rate with a swap point. The swap point will be based on the interest rate differential between the two currencies, considering the prevailing benchmark rates. For example, the three-month term secured overnight financing rate (SOFR) for the US dollar and the policy rate of the BB for taka will be applicable. The SOFR is a benchmark interest rate for dollar-denominated derivatives and loans that replaced the Libor (London Inter-Bank Offered Rate). The SOFR rate is currently 5.38 percent, while the policy rate in Bangladesh is 8 percent.
The swap deal will be executed within the counterparty limit set by the Forex Reserve and Treasury Management Department of the BB. Each deal will be in multiples of one million foreign currency, starting from a minimum value of five million and equivalent taka. The tenure of the swap will range from seven days to 90 days, and the rollover may be allowed by applying the prevailing rates. The BB will also charge a commission fee of 0.05 percent per annum on the swap amount.
For Shariah-based banks, the swap mechanism will be slightly different, as they are not allowed to pay or receive interest. At the near-leg, the BB will sell taka to banks in exchange for foreign currencies at the spot rate. At the far-leg, the BB will buy back the same amount of foreign currencies from banks at the same exchange rate, without any swap point.
Benefits of currency swap?
The currency swap system has several benefits for both the BB and the commercial banks. For the BB, the swap will help to temporarily increase its foreign exchange reserves and meet the IMF’s NIR target. The swap will also enable the BB to diversify its reserve portfolio and reduce the risk of exchange rate fluctuations. The swap will not affect the market exchange rate, as the BB will not intervene in the interbank market. The swap will also not create any money supply pressure, as the taka sold by the BB will be sterilized by issuing treasury bills or bonds.
For commercial banks, the swap will provide an opportunity to earn interest income from their surplus foreign currencies, which would otherwise remain idle or be invested in low-yielding assets. The swap will also help the banks manage their liquidity and foreign exchange risk, as they can borrow or lend foreign currencies from or to the BB at a predetermined rate. The swap will also enhance the efficiency and stability of the foreign exchange market, as it will reduce the volatility and speculation in the market.
Challenges of currency swap?
The currency swap system also has some challenges and limitations that need to be addressed. One of the challenges is the availability and adequacy of foreign currencies in the banking system. The BB will depend on the banks to supply foreign currencies for the swap, but the banks may not have enough surplus dollars or may be reluctant to lend them to the BB, especially if they expect a depreciation of the taka or an increase in the demand for dollars. The BB may also face a mismatch between the demand and supply of different foreign currencies, as the banks may prefer to swap certain currencies over others.
Another challenge is the pricing and valuation of the swap. The BB will have to ensure that the swap rate and the swap point are fair and transparent, and reflect the market conditions and expectations. The BB will also have to monitor and adjust the swap rate and the swap point regularly, based on the changes in the interest rates and the exchange rates of the relevant currencies. The BB will also have to account for the swap transactions in its balance sheet and report them in its reserve data, following the international standards and best practices.
A third challenge is the regulation and supervision of the swap. The BB will have to ensure that the swap transactions are conducted in a safe and sound manner, and comply with the prudential norms and guidelines of the BB. The BB will also have to oversee the risk management and internal control systems of the banks involved in the swap, and prevent any misuse or abuse of the swap facility. The BB will also have to coordinate and communicate with the other stakeholders, such as the government, the IMF, and the public, about the objectives and outcomes of the swap.
The currency swap system introduced by the BB is a new and innovative way of managing the foreign exchange reserves of the country. The swap will help the BB to meet the IMF’s NIR target, diversify its reserve portfolio, and reduce the exchange rate risk, without affecting the market exchange rate or the money supply. The swap will also benefit the commercial banks, as they can earn interest income, manage liquidity and foreign exchange risk, and contribute to the efficiency and stability of the foreign exchange market. However, the swap also poses some challenges and limitations, such as the availability and adequacy of foreign currencies, the pricing and valuation of the swap, and the regulation and supervision of the swap. The BB will have to address these challenges and limitations effectively and ensure that the swap system serves the best interest of the country and the economy.
