As an intro to a five-nation summit in South Africa, China and Brazil this week announced an agreement to swap their currencies to support trade if necessary in some future crisis. What does this actually mean, and why are they doing it?
And does this threaten the "exorbitant privilege," as a French official once put it, that our country gets from the U.S. dollar's role as the common currency of much international trade?
Currency swaps between countries are handled by their central banks, i.e. the U.S. Federal Reserve. From time to time they are necessary, because one of the functions of a central bank is to maintain an orderly availability of "foreign exchange."
Foreign exchange consists of the currencies of other countries (or gold) that can be used to pay for imports, pay debts abroad or to invest in other countries. While any other nation's currency can function as foreign exchange, in practice, major "hard currencies" such as the U.S. dollar, Euro, British pound or Japanese yen dominate. No one really wants to be paid in Paraguayan Guaranis or Angolan kwanzas unless they have an immediate need to buy from those countries.
Currencies from countries that don't allow a free market in the buying and selling of foreign exchange are not commonly acceptable in currency markets. Hence, while China is a major economy, the yuan is not widely held by businesses or other central banks.
For nations that do allow free trading in their currency, anyone needing to make a payment to another country can get the needed foreign exchange through normal banking channels. The rate may fluctuate from day to day or even hour to hour.
For nations like China, or now Cyprus, that maintain "exchange controls," if you need to make a payment in another country, you or your bank must go to your own country's central bank to get a currency that is acceptable to whomever your counterparty is. Note that you don't necessarily need the currency of the other country. A Uruguayan contractor buying Volvo dumpers from Sweden doesn't need Swedish krona. Volvo will be happy to accept euros or U.S. dollars at a specified exchange rate. The price in the sales agreement may even be in those non-Swedish currencies.
Even without exchange controls, central banks act as buyers and sellers of foreign currencies to maintain orderly conditions in the markets for their currency. If more Bulgarians want to sell euros and get levs than there are people wanting to buy euros with levs, the Bulgarian central bank will buy these euros. And if the reverse is true, the central bank will sell euros. If they don't, market forces will make the price of the euro, in terms of levs, fluctuate. A bit of fluctuation is OK, but many countries want to damp down wild swings.
As long as there is excess demand for a country's own currency, the central bank can always supply it because it can always create more. It can never run out of levs. But it can only buy levs with euros to the extent of the stock of euros it begins with, unless it has an agreement to get more.
Such an agreement is called a "swap arrangement." If the Bulgarian central bank has such an agreement with the ECB, it can give the ECB levs and get euros in exchange. However, at some specified time in the future, it has to reverse the transaction, giving the ECB its euros back and accepting its own levs.
The Federal Reserve has such swap arrangements with other central banks. During the second week of August 2007, when European markets for short-term borrowing by corporations locked up, the ECB dumped dollars and euros into this market. In other words, they stepped in and loaned money by buying up this "commercial paper" themselves or made loans to financial institutions that would.
But they soon were running out of dollars. So they got more from the U.S. Fed via a swap, which got reversed some months later. Swaps between central banks of major countries are always repaid, virtually without historical exception.
It is just such an arrangement that Brazil and China recently reached. It will be needed only if there is an international financial crisis of such proportions that there would be a shortage of dollars, or other major currencies, in one or both of the partner countries.
In ordinary times, a Chinese margarine factory that wants Brazilian soybeans can get U.S. dollars from the Bank of China. Since Brazil allows free trading in its currency, the Brazilian soybean exporter accepts the dollars knowing they can be turned into reals. And the Banco Central of Brazil will usually buy them in any case.
However, if the global market for dollars suddenly dried up, such deals would be difficult. The Bank of China would give yuan to the Banco do Brasil and would accept reals. The margarine importer could then get reals from the Bank of China instead of dollars to pay for a shipment of soybeans.
Would this hurt the United States? If taken to an extreme, yes. When other countries hold on to reserves of dollars, they are, in effect, making an interest-free loan to the U.S. Treasury. (It would take another column to explain why this is true.) So if the dollar lost this status as a "reserve currency," then it would lose value in foreign exchange markets or the Treasury would face higher borrowing costs.
That may well happen in the long run if China makes the yuan freely convertible and it becomes widely seen as a trusted reserve currency. But the agreement just announced is only a tiny step in that direction. It is largely for show, as a public demonstration of these countries' independence from the U.S. and Europe. There is little substance, and it doesn't hurt us.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at firstname.lastname@example.org.