What is Currency Swap?
Simply put, it is an agreement between two parties to swap their currencies without involving a third party and thus avoiding a risk of changes in third party currency.
In this case, it is an arrangement between Nigeria and China, which have substantial or increasing trade, to basically involve trading in their own local currencies which they use to pay for import and export, at pre-determined exchange rates, without bringing in a third country currency like the US Dollar.
Such arrangements are increasingly becoming a norm between major economies and help enhance the armoury of central banks concerned to cope with sudden financial shocks.
This agreement is usually done by two countries for a predetermined amount and exchange rate and passed on to businesses.
In the Nigeria China deal we hear it is for somewhere between $2 billion and $4 billion.
How will it work?
In the case of the Nigeria-Chinese deal, the Peoples Bank of China will accept naira (NGN) and give Yuan to the Central Bank of Nigeria (CBN).
For example the CBN converts $2 billion of Nigeria’s external reserves to Naira ($2 billion X N200 = N400 billion) and deposits it with the Peoples Bank of China.
The Chinese counterpart will then also give Nigeria the Yuan equivalent of $2 billion.
If a Nigerian trader wants to import (CBN approved) goods from China. He would have to approach a Nigerian Bank and pay say N60 million for $300 million (at N200/$) or whatever exchange rate that governs the swap deal between Nigeria and China (which has not been revealed by both parties).
The Nigerian Bank will then open a letter of Credit approved by the Industrial and Commercial Bank of China (ICBC).
The Nigerian Bank then credits ICBC with N40 million and his goods are shipped.
The reverse is the case.
If a Chinese firm wants to import oil or gas from Nigeria.
The firm goes to the ICBC to open an LC for the naira equivalent of the oil being imported to China and ICBC pays NNPC with naira at N200 x dollar value of oil being sold.
How will it impact Trader’s/Nigerian Companies?
Suppose a Nigerian company ‘A’ wants to buy machinery from a Chinese company ‘B’, but company ‘B’ is accepting its payments only in Chinese Yuan (CNY).
The normal procedure would be to convert NGN to USD and then to convert USD to CNY.
This involves risk of change in value of currency in two stages.
With the Naira/ Yuan swap deal in place, it reduces the risk and charges involved in multiple currency exchanges.
Suppose a small Chinese company ‘C’ wants to expand its business in Nigeria.
It needs investment in the local currency NGN.
Company ‘C’ doesn’t have any collateral and thus becomes a risky investment for the banks in Nigeria to loan to.
Nigerian Banks would be forced to lend to company ‘C’ at a higher interest rate which will eat into profits of company ‘C’.
Now if there is a Nigerian company ‘D’ looking to invest in China.
It also faces the same problem.
In order to avoid this, the two companies (Nigerian and Chinese) can partner and get loans in their homelands at normal interest rates and do a currency exchange.
This way they are saving on interest and exchange charges too.
Bottom-line, it can minimize borrowing costs for both firms.
How will it impact Speculators?
For currency speculators it is a little bit trickier as it may involve setting up shell or real companies, and partnering with those with access to swaps to import, colluding with customs and then sharing the profits.
In this case an unscrupulous or enterprising Nigerian company ‘E’ let’s call it Wazobia and sons notices that the fixed Naira/Yuan used for the swap deal signed with Nigeria is now weaker than the market rate for Yuan in China.
In other words let us say the rate the agreement was signed between Nigeria and China was N200/$1/6 Chinese Yuan (which clears at 1 CNY/N33).
And assume this is a fixed rate (per the agreement) for a period say 2 years.
If after 4 months the Yuan appreciates to $1/4 CNY, it means the new FX rate in the real world is closer to 1CNY/N50.
Chinese goods should in theory now be more expensive for Nigerian importers without access to the swaps to buy.
The Nigerian Company Wazobia and Sons can then partner with a company with access to swaps that is authorised to ship in machinery (or items not banned by CBN) so they can ship in half machinery and half phones/textiles/electric coils/etc (Items banned by CBN) from China.
They can sell these products for a huge profit and undercut the competition (without access to CBN swaps) that is purchasing the Yuan at black market rate of N320/$1/CNY 4 or near N80 per Yuan.
In other words it will be another form of round tripping, using real goods. Think this is all far fetched? Think again!!
This was rampart 7n the 1980’s during the time of essential commodities and counter trade under the regime of you know who.
Indians and other connected Nigerians were given access to import machinery to produce essential commodities at near N1/$1 exchange rate and they became instant dollar millionaires by importing unusable scrap or sand in collusion with Nigerian customs.
Bilateral trade between Nigeria and China has grown rapidly in the last decade, rising some 430 % to $14.9 billion in 2015, from $2.8 billion in 2005.
In 2015, Nigeria accounted for nearly 8.3% of the total trade volume between China and Africa.
The swaps deal between Nigeria and China has some positives but it also could be abused by unscrupulous merchants.
In the end there is no alternative for Nigeria to letting market forces determine its exchange rate to deter distortions and bring back FDIs and portfolio inflows.