China currency swaps and prepping for the last monetary frontier

China seems to be waiting patiently in the wings, as the U.S. dollar may be starting its next decent just in time for another EU crisis to emerge.

China has been negotiating currency swaps in preparation for the day it must intervene on the world monetary front, perhaps making its currency, the yuan, a defacto candidate for reserve currency status as the dollar’s fortunes decline.

Currency Swaps

Currency swaps are typically motivated by comparative advantage, and the term can refer to two different types of transactions as follows:

  • In the foreign exchange market, a currency swap is an agreement between counterparties to exchange one currency for another on one value date and then reverse the transaction on another value date.
  • In the interest rate swap market, a currency swap can also refer to the exchange of principal and/or interest payments of a loan in one currency for an equivalent loan in another currency. This sort of currency swap should be distinguished from a liquidity swap performed by a central bank.

Central Bank Liquidity Swaps

In the 2008 global financial crisis, the Fed used forex currency swap transactions to enter into central bank liquidity swaps. In these foreign exchange deals, the Fed and the central bank of another major economy agreed to exchange their national currencies at the prevailing market exchange rate and simultaneously agreed to reverse the transactions at the prevailing forward market exchange rate on a specified future delivery date.

The stated goal of these central bank liquidity swaps was to "to provide liquidity in U.S. dollars to overseas markets." Although central bank liquidity swaps and forex currency swaps are structurally identical, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps instead represent emergency loans of U.S. dollars to foreign markets via their respective central banks. 

It is currently undetermined if these transactions will benefit the U.S. dollar or the United States over the long run, although they do represent an extension of credit to overseas nations.

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