Sunday, 22 February 2015

CURRENCY SWAP OR SOVEREIGN DEBT?

Sunduzwayo Madise
22 February 2015

The other day (Nation, 12 February 2015) the Minister of Finance was quoted to have said that one of the reasons for the Kwacha’s appreciation in value was a currency swap deal that Treasury had done with the PTA Bank. Now any attempt to stabilise our currency must always be commended but maybe the question to be asked is at what cost to us, and to the future generations. The Minister was quoted that the deal was worth $250 million (about K18 Billion) but that this does not mean Malaŵi had borrowed (heavily) from the PTA Bank but rather the deal was simply a currency swap and that ‘nobody will lose out’. According to the article, the PTA Bank paid to the Reserve Bank of Malaŵi (RBM) in US Dollars, and the central bank was acting as the agent of Treasury. The Minister is quoted further to have said:
instead of us owing the RBM, we owe PTA Bank. They paid that borrowing from RBM in Dollars. This is called currency swap because nobody is losing out. RBM bought Dollars so you could also say PTA bought Malaŵi assets from RBM, so it is a swap and there is no borrowing.  

This immediately raised some eyebrows amongst financial experts who most agreed that this was not a currency swap but rather an issue of sovereign debt. In order to delve further and analyse what has happened; it is imperative that we look at these two financial terms and what they mean.

Currency Swap
A currency swap involves the exchange of principal and interest in one currency for the same in another currency. It is therefore essentially a foreign exchange agreement of a loan in one currency for equivalent aspects of an equal loan in another currency; although it need not be restricted to a loan. In corporate finance, it is treated for all purposes as a foreign exchange transaction. Let us give an example of a typical currency swap. Suppose for example a Malaŵian company requires South African Rands and a South-African company needs Kwachas. These two companies will then agree a currency swap deal to allow them to access the currency they require. They will agree upon the interest rate as well as a common maturity date.  Currency swaps can also be done by states and between states and other corporations, usually but not always, of international nature.

Currency swaps are all about obtaining financing at mutually beneficial terms.
  1.  They allows parties to secure cheaper financing (usually debt).
  2. They are also an insurance of sorts, a type of risk-mitigator. It is a way to hedge against exchange rate fluctuations, especially for countries whose currencies are susceptible to volatile swings in the exchange rate (mostly of a depreciative nature). 
  3. It provides a buffer against financial instability and turmoil which could arise by a crisis in the liquidity since the borrower borrows with its own currency. Consider a situation where the borrower borrows in foreign currency and then the local currency significantly loses value, the borrower would face a liquidity crisis as it would need to acquire more of its local currency to pay back an equivalent in the foreign currency.

 So let us apply this to our current situation in which the Minister is quoted to have said that we have entered into a currency swap with the PTA Bank. This would mean that the PTA Bank needed Kwachas and we needed Dollars under a loan deal arrangement (mutual borrowing). We then went into a deal to pay in Kwachas for Dollars in a reciprocal loan arrangement with an agreed interest rate for a set period. Is this what happened here?

Sovereign Debt
Sovereign debt refers to bonds (IOUs) issued by governments in a foreign currency. It is important to distinguish this with the bonds issued by the government domestically in its local currency, such as Treasury Bills or the recent issued Zero-Coupon Bond. Sovereign debt is targeted to international investors, including governments. It is common for governments to buy each other’s debt. For example China is the biggest buyer  of US debt. But because the US Dollar is freely convertible, the US does not have to issue its sovereign debt in a foreign currency other than the US Dollar. In contrast, if a country like Malaŵi decided to issue sovereign debt in Kwachas, the chances are it would not be bought because internationally the Kwacha is not considered a freely convertible currency. It is also considered a premier currency. Several factors influence this such as economic strength of the country of issue, stability of the currency play and foreign exchange restrictions. Most currencies of third world countries cannot be traded on the international bond market.

Sovereign debt is guarantee by the state. Therefore if the country is financial stable, and has good development indices, its debt will be deemed a safe investment. Internationally these debts are rated and those considered risk-free are given the highest ranking of AAA (Standard & Poor and Fitch ratings). Debt from developing countries is usually perceived as riskier and to hedge against risks associated with it, may be sold only if the returns (dividends) are much higher. The term junk bonds is sometimes used to bonds considered of non-investment grade. On the flip side, junk bonds are high-yield bonds, and characterise most bonds from third world countries. There are investors who actually specialise in buying junk bonds because of their high return. If one thinks about it, it is really easy to understand why. Suppose you go to a bank to get a loan, if at the end of the bank’s assessment you are a risky borrower, the only other way you may get the credit (other than being denied) is to get in on very high interest. The high interest reflects the risky nature of the transaction. The bank is hedging its risk by charging higher interest. The case of the katapila lender quickly comes to mind! Katapila is a risky business. Chances of default are high. To mitigate against this, the interest rates are high (mwala ku mwala – 100% per month is not uncommon).

Analysis of the Minister’s words
Let us be clear on one aspect, both currency swaps and sovereign bonds involving loans. Therefore to say there is no borrowing involving a currency swap is simply not true. A currency swap in corporate finance is not just an exchange of currencies. The fundamental difference is that a currency swap is mutually beneficial and in this way, the Minister is correct that nobody loses. Everyone pays (back) in their own local currency and that is where everyone benefits (if you discount the cost of borrowing itself). But is what happened here a currency swap?

According to the quote attributed to the Minister, the deal can be broken down into:
  1. And agreement by Treasury with the PTA Bank to make available finance in foreign exchange amounting to $250million (he says this is not borrowing) 
  2. PTA Bank will pay the funds via the Reserve Bank (acting as agent of Treasury) 
  3. This will mean that instead of Treasury owning the central bank, it will owe the PTA Bank
  4.  RBM has ‘bought’ the Dollars and PTA has bought Malawi’s assets (and according to the Minister there is no borrowing).

 Now looking at the above steps, it becomes quickly self-evident that there is confusion of corporate finance principles being brought in here. The agreement to have PTA Bank make available to us through then central Bank $250 million is clearly a loan, one involving sovereign debt. We are selling our national debt to the PTA Bank. Put in another way, we have agreed on a loan with the PTA Bank through which we will borrow $250 million to be repaid to them at an agreed interest over an agreed time. But we will have to pay back $250 million in foreign exchange plus interest.

The second and rather contradictory aspect is that Malaŵi and the PTA Bank have agreed to sell each other something. PTA Bank has agreed to buy some unnamed Malaŵi assets for the price of $250 million.  RBM is said to have bought the Dollars and PTA to have bought our assets. The first question is with what has the RBM bought the Dollars? With Kwachas? Or with some other unnamed assed? And the follow up question is if this ‘asset’ is not sovereign debt, then what asset have we sold to the PTA Bank? If it is sovereign debt then there is no currency swap and the issue is settled. But even if it was not sovereign debt, would it still qualify as currency swap? To answer this we must ask ourselves the question: have we had exchanged loans with the PTA Bank and agreed that we would pay them in Kwachas whilst they pay us in Dollars? Is this what has happened here? From what we have been told, the answer would have to be in the negative.

Concluding remarks and further thoughts
This is not a currency swap. We have sold sovereign debt to the PTA Bank and there is need to disclose the full deal in terms of maturity and the interest (yield) that is payable and when this is payable. And whilst we are at it, we may start considering how many Kwachas we will need at the date of maturity to repay the $250 million because when it matures, there will be a legal obligation to pay. It is only after making this analysis that we can make draw conclusions whether this deal is good for us as a country. The agreement is not just a financial one, it is a legal one too. Legal rights and enforceable legal obligations arise from it.

And this also applies to all other international loans. I have heard successive finance ministers boasting about how the country was getting a good deal because the loan they had negotiated was of zero percent (0%) interest. I have always wondered whether they are ignorant of what they are saying or they do not understanding how the world of finance actually works. Let me explain this by using a simplified example. Suppose we borrow $1 million in 2015 at 0% interest; and the loan is to be repaid after 20 years. The good thing is that when the loan matures in 2035, we would only be required to pay back $1 million (the terms of repayment would depend on the terms of the loan agreement). But suppose in 2015 the Kwacha is at $1 = K450 and suppose in 2035 the Kwacha has depreciated substantially and is at $1 = K4,500 (God forbid). This means that in 2015 we received K450 million as a loan but come 2035; we would have to pay back K4.5 Billion. Now anyone who says that by obtaining a loan in foreign currency at 0% or at a low interest rate is a deal needs to recalculate the actual cost of borrowing by factoring in the depreciation of the Kwacha over time (economic and statistical models are available to do this and make projections) . I have noted that apart from Treasury, several Malaŵian corporations have also borrowed from international financiers, especially on the London loan market (in Pound Sterling). I do hope they have done a proper due diligence of the actual cost of the loan. It maybe sometimes be cheaper to borrow locally and pay back in good old Chilembwes!


Coming back to the issue of currency swaps, and considering that the Minister of Finance is an expert in finance, I can only conclude that he has been misquoted. 

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