Central Bank Swap Agreements

For example, the Federal Reserve provides U.S. dollars to a foreign central bank. At the same time, the foreign bank makes available to the Fed the corresponding amount of its currency. The value is based on the exchange rate of the market at the time of the transaction. The use of foreign exchange swaps to generate reserves is difficult to distinguish from central bank swaps used to stimulate financial markets or subsidize certain activities. For example, central banks that act as market makers in futures markets, provide futures and exchange rate guarantees, subsidize domestic financial institutions and attract foreign investment. Some of these activities are quasi-tax transactions involving subsidies; they are very common in developing countries. Whatever the purpose, these transactions are similar to those discussed above: they result in the central bank occupying an open position and thus assuming the exchange risk, which often results in significant losses. Such activities are generally not recommended. Central banks can do more to stimulate financial markets through a credible exchange rate policy.

Subsidies should be included in the state budget and the financial sector will not win in the long run if its central bank incur large losses, which most often need to be monetized. Deutsche Bundesbank has a transaction (“foreign exchange transactions in the context of repurchase transactions”) that is very similar to a swap and is treated in this way (see section 3.1). Keep in mind that these are currency swaps that are interest swaps, not foreign exchange swaps. The overall cap on swaps for the banking system increased from 12.7 million ROs in 1981 to 50.6 million in 1986. Then the ceilings became variable, with different costs for different portions. Swap lines are agreements between central banks to exchange their country`s currencies. They hold a foreign exchange offer for trade with the other central bank at the current exchange rate. As a means of defending foreign exchange reserves during balance-of-payments periods, the adequacy of foreign exchange swaps is much more questionable.

In countries where these problems are acute, swaps can have negative effects because they leave the central bank with an open monetary position that almost always results in losses. For the same reason, it is not recommended to use central bank swets to stimulate the development of financial markets. Losses to central banks could seriously affect monetary policy and, therefore, monetary stability. In countries with moderate and temporary balance-of-payments difficulties, swap systems can be useful as a temporary means of increasing a country`s gross foreign exchange reserves.

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