On 9 October 2013, the central banks of China and the European Union (EU) signed the bilateral currency swap agreement with a volume of 350 billion RMB (ren min bi, the Chinese currency), around 45 billion euros. From a historical perspective both China and the EU have signed many currency swap agreements with other countries, but this is the first time that the two largest economies in the world signed a currency swap agreement. Why did they sign the agreement? And what is the impact of the agreement on both China and the EU?
A brief introduction
A currency swap agreement is an international financial derivative tool. It is an arrangement in which two parties exchange specific amounts of different currencies. Then series of interest payments on the initial cash flows are exchanged. At the maturity of the swap, the principal amounts and the interests are exchanged back.[i]
The 350 billion RMB/45 billion euros currency swap between the central banks of China and the EU will be valid for three years and is a big step forward to further cooperation and exchange. It has been established at the level of the euro system and will be available to all euro system counterparties through national central banks.[ii]
For different reasons, the swap with the European Central Bank (ECB) is quite different from previous swaps. It can be seen as one with central banks of the member states; therefore it is not a bilateral, but a multilateral agreement. It also has greatly broadened the geographical view. China mostly signed currency swap agreements with Asian countries. Considering the degree of development, the previous partners are mostly developing countries. This time the currency swap agreement has only developed continental countries involved. Please note that the numbers of Hong Kong (China), South-Korea and Singapore are the cumulative ones of the currency swap contract and its renewals.
Since 2010, China has become the world second largest economy ranking second after the United States (US). But if we take all the EU-countries together, the EU as a whole will surely surpass the US and China and become the largest economy in the world. If we look into the amount of Chinese currency swaps since 2008, this one with the EU is no doubt the largest.[iii]
Currency swap has long been used among countries. Especially during the global financial crisis, it has been widely applied. In 2013 it was the first time that China and the EU entered into a currency swap agreement. Why did it take so long?
According to the ECB, ‘the swap arrangement has been established in the context of rapidly growing bilateral trade and investment between the euro area and China, as well as the need to ensure the stability of financial markets’.[iv] One of the shared factors between China and the EU is the development of bilateral trade and investment. Ever since 2003, China has become and maintained the second largest trade partner of the EU after the US. China is also the largest source of import of the EU. At the same time, the EU has remained China’s largest trade partner for almost nine years. The close trade and investment relationships between China and the EU have made it necessary to seek for solutions to reduce trade costs and avoid risks of exchange rate fluctuations. As a sort of monetary tool, currency swap offers a solution for these problems. The development of mutual trade and investment has therefore provided the motivation for the move of currency swap.
However, this motivation was not enough. To take the final step, some external factors were important. The liquidity shortage both in China and the EU may have played an important role. Liquidity means the ability to convert an asset to cash quickly. When the market doesn’t have enough money to buy assets or pay the debt, we say the market is faced with liquidity shortage. Although the global financial crisis has gradually faded out and the world economy has been in recovery, Europe has been haunted by the sovereign debt crisis ever since 2009 and is still slowly recovering. Of all the problems, shortage of liquidity is one of the key concerns. The sovereign debt crisis is just a result of shortage of liquidity. To deal with this, the European Financial Stability Facility (EFSF) and the European Financial Stability Mechanism (EFSM) are established to bail out the countries caught in the sovereign debt crisis by providing liquidity at the beginning of the crisis. Mid-2013, the European Stability Mechanism (ESM) has replaced these two temporary mechanisms to establish a permanent firewall for the Eurozone. It helps to safeguard and provide instant access to financial assistance programs for member states of the Eurozone in financial difficulty, with a maximum lending capacity of 500 billion euros. The ESM cooperates very closely with the International Monetary Fund (IMF). A euro area member state requesting financial assistance from the ESM is expected to address, wherever possible, a similar request to the IMF.[v] Until now, the shortage of liquidity is still a problem puzzling the EU.
China has also been plagued by the shortage of liquidity during and after the global financial crisis. The crisis has caused global liquidity shortage and financial market participants’ confidence in financial system has suffered serious problems. As a result, the real economy (especially trade and investment) was seriously hit. Even after the crisis, in June 2013, China experienced a large wave of ‘lack of money’, which has caused great panic in the financial market. In the first week of that month, many financing institution started to largely borrow money, which caused a liquidity shortage. On June 19th, the closing of the interbank market was delayed for half an hour, which has greatly shocked the financial market. The situation has deteriorated since then. On June 20th, the overnight bank loan interest rates surged to 30 percent, and that is the third time that it has come to such a high position ever since the end of 2010.
The tightening monetary policy adopted by the People’s Bank of China (PBC) has made it worse. The ‘lack of money’, which is grown out of the bank system, has spread to the capital market. In the interest market, a rise in all sorts of interest rate terms has appeared. The bank system and the market in China faced the most severe problem of money shortage. This shortage problem lasted for about one month and ever since, the market has been haunted with the expectation of tight liquidity.
Apart from the shared factors discussed above, most important is the promotion of the internationalization of China’s national currency. China has put it on the agenda for many years and steps have already been taken to realize this step. A currency swap agreement with another country is part of this process. The EU is the largest economy in the world and the euro is not just used as a transaction currency, but also as a reserve currency. Currency swap between the PBC and the ECB can greatly promote the progress of the internationalization of RMB since it gets some major developed continental countries such as Germany, France, Italy and The Netherlands involved. All together, these countries have a population of over 330 million people and a total GDP of 9483.5 billion euros (in 2012).[vi] The agreement with the central bank of the EU is just a matter of time. Due to the shortage of liquidity in October 2013, it was the right time.
From the EU point of view, the agreement of currency swap between China and Britain in June with a volume of 200 billion RMB (20 billion pounds) may have promoted the signing of the agreement between the PBC and the ECB. The ECB, the Federal Reserve and the Bank of England are considered the three most influential banks in the world. Because Britain has not joined the Eurozone, in some areas, the ECB and the Bank of England are competitors. As we all know, the ECB is located in Frankfurt and the Bank of England is located in London. These two countries are in competition for becoming the RMB offshore center in Europe. The agreement of currency swap between China and the Britain in June can be seen as a step taken by Britain to establish its own RMB offshore center. However, this step has promoted the currency swap between the PBC and the ECB.
Impacts of the currency swap
As discussed above, the development of bilateral trade and investment has promoted the signing of the agreement. In return, the currency swap is beneficial to its development. Through currency swap, foreign liquidity can be pumped into the domestic financial system. Therefore, domestic firms can borrow foreign currencies to import goods. And this allows the export firms to receive payments for goods set by the domestic currency, which can help the firms to avoid the risks of exchange rate fluctuation and reduce foreign exchange costs. After signing the swap agreement, the firms both in China and the EU can swap substantial benefits. The trade and investments between China and the EU will become more active and the bilateral economic relationship will be even better. Closer economic relation can pave the way for further cooperation in other areas.
The currency swap also indicates potential reduction in the use of dollars in trade for both sides. The currency swap allows to use both the RMB and euro in bilateral trade, which will make both China and the EU less dependent on the US-dollar. As the US-dollar is the most widely used currency in the world and lots of debts and assets are dollar-dominated, the holders of these assets are faced with great risks of default and the fluctuation of exchange rate, when the economy of the US goes downward.
The outbreak of the subprime mortgage crisis and the global financial crisis caused by it can just indicate the great impact the US-economy has on the world. And in the crisis, the holders of the US treasury securities have experienced great losses. In fact, both China and the EU hold lots of the US treasury securities, before and after the crisis. In China’s case, the amount of foreign reserve was 3662.662 billion dollars in November, 2013, and according to the data from the US Department of Treasury, China possesses of 1293.8 billion dollars of the US national debt, which is about 35 percent of the total foreign reserve.[vii] And it went up to 1304.5 billion dollars. China has remained the largest holder of the treasury securities ever since the 2008-2009 global financial crisis. In the EU’s case, eight countries of the Eurozone (Belgium, Luxembourg, Ireland, Germany, France, Netherlands, Italy, and Spain) possess of a total number of 799.6 billion dollars of the US treasury securities.[viii] Large amount of the US treasury securities means large risks and losses if the economy of the US goes downhill. And selling off large shares of the US treasury securities will just cause larger losses in the foreign reserve. Therefore, especially China has been in an awkward position.
The currency swap can gradually help reduce the use of dollars in bilateral trade and in the foreign reserve and hence reduce the dependence on the dollar. This allows the euro to be used more frequently in bilateral trade and is beneficial to the improvement of the status of the euro as an international transaction currency and reserve currency. As for the RMB, the agreement with the ECB manifests the improvement of the RMB in the international monetary system, which is a big step forward in the progress of internationalization of the RMB.
Beneficial as it is, we should notice that the volume of currency swap is still not large compared to the bilateral trade volume. In 2012, the volume of bilateral trade between China and the EU was around 330 billion euros. And the 45 billion euros just took up about 13.64 percent of the total trade flow. Compared to previous currency swaps between China and other countries, this is not high: the currency swap between China and South-Korea takes up about 23 percent of the total bilateral trade volume. Therefore, this round of currency swap between China and the EU may be seen as a trial. There is space for further cooperation.
The RMB has just started it progress for internationalizing. It is not yet a reserve currency. The active demand for the RMB is mostly based on the expectation of the appreciation of the RMB.
In short, a lot needs to change in order to prepare for further cooperation. The internationalization of the RMB calls for deeper reform of the domestic financial market and there are many restraints. In the short run, the status of the RMB and the euro in the international monetary system will remain unchanged and it will take a long time to weaken the hegemony position of the US dollar. Therefore, the instant impact is majorly on the bilateral relationship between China and the EU. In the future, there should be a complementary relationship between the RMB and the euro. Seeking for win-win cooperation should be the common goal.
Qiaolin Liu (1990) is pursuing a master degree in Economics at the Fudan University in Shanghai, China.
[i] ‘Currency swap’, China Daily (October 16 2006) available online via: http://www.chinadaily.com.cn/
business/2006-10/18/content_710951.htm (last time consulted on May 26 2014).
[ii] ‘ECB, ECB and the People’s Bank of China establish a bilateral currency swap agreement’, Press Release European Central Bank (October 10 2013) available online via: http://www.ecb.europa.eu/press/pr/date/2013/html/pr131010.en.html (last time consulted on May 26 2014).
[iii] Website The People’s Bank of China, available online via: http://www.pbc.gov.cn/ (last time consulted on May 26 2014).
[v]‘About us’, European Stability Mechanism, available online via: http://www.esm.europa.eu/about/index.htm (last time consulted on May 26 2014).
[vi] Website Eurostat, available online via: http://epp.eurostat.ec.europa.eu/ (last time consulted on May 26 2014).
[vii] Available on the website of the State Administration of Foreign Exchange of China: http://www.safe.gov.cn/ (last consulted on May 26 2014).
[viii] Available on the website of the US Department of the Treasury, Major Foreign Holders of Treasury Securities: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt (last time consulted on May 26 2014).