Beware the EM central bank FX swap trend BNP Paribas has an interesting note out on the increased use of FX swaps by central banks. If you're a central bank in emerging markets, struggling to keep your economy stimulated/protected from hot money flows, using swaps or FX sales is a tempting and viable alternative to interest rate hikes, they note. And generally speaking, the BNP EM strategists argue, swaps provide for a richer toolset for most central banks. Just ask one of the trend-setters Brazil: Following the sharp depreciation of emerging market (EM) currencies on the back of the prospects of Fed tapering and the halt of excess liquidity flows into EM economies, some central banks started intervening in the FX market to curb depreciation pressure on their currencies1. However, what has attracted attention this time is that most of the CBs intervening in the FX market are relying on a different tool rather than the usual sale of their international reserves, namely the offer of USD via FX swaps. In Brazil, this has been a recurrent choice of FX intervention over the past couple of years when it seemed the BCB has reached its optimal level of international reserves. Whenever they want to prevent sharp movements on the USDBRL, they opt to sell USD via currency swaps or to buy USD via reverse currency swaps. Now, this sort of FX intervention has been spreading out among other EM countries with India and Indonesia following the BCB's steps, although with some differences. We think this can be feasible for Turkey as well. A notable and recent copycat has been India, which on August 28 decided to engage in USDINR FX swaps for fixed tenors with oil companies, in a bid to shore up the rupee. As BNP Paribas" team explains, while the swap tactic can make your reserves go further - in almost shadow banking style - its success is dependent on whether the sought after intervention actually works, or else there could be basis risk exposure as well as real world counterpart risk: Effectively, RBI is lending USD to the oil companies, not selling USD spot. The immediate impact on the market was positive as the market took this to mean that RBI had taken oil import USD demand out of the market. Another (unexpected) consequence of the swap facility was to widen the cross currency basis as the RBI started doing buy/sell FX swaps with the market, presumably to prevent a decline in its spot reserve numbers. One consequence not yet priced in by the market is potential losses for oil importing companies in the event of INR depreciation. If this measure works and the INR appreciates, the USD loan against RBI could be repaid at a profit. But if the INR depreciates, then oil companies would incur losses. In that event RBI would need to keep rolling these swaps or the government would have to take a fiscal hit. India was the most reluctant among these CBs to hike rates and these FX interventions do not seem to be enough to cope with the depreciation pressure, as INR has remained the weakest performing among EM currencies (Chart 1). Which all becomes a bit head numbing if you believe there is potential for a central bank with relatively limited foreign reserves to lend them out - almost in fractional reserve fashion- so as to top up dollar denominated liquidity in the foreign exchange market. In India's case there is no naked shorting at the moment. What India is lending, it is currently reborrowing on a forward basis from the market. If the exchange rate moves in favour of the domestic currency the strategy can pay off considerably for the EM central bank. If it doesn't, the outstanding dollar-denominated funding mismatch must eventually be plugged with real reserves - or in the event that these are drained entirely, by tapping the Fed's own FX swap window to plug the dollar shortage. Either way, it is a move that temporarily prints dollars into the system. The fact that these moves come after Fed tapering panic, meanwhile, arguably tell us a lot about global appetite for dollar liquidity. It's almost an indirect message to the Fed saying that if you stop dollar easing, we'll turn to more innovative ways to plug the shortfall ourselves. But as BNP Paribas themselves conclude, it might be a risky strategy. If the exchange rate fails to move, or the Fed's resolve proves stronger than that of EM central banks, somewhere basis risk losses will have to be worn. At best, swaps might only delay inevitable depreciation: Overall, EM CBs are opting to intervene via FX swaps, given that the level of international reserves is not affected. Although their intervention might calm down the FX market in the very short term, they will not solve the underlying problems - evidenced by a large current account deficit - behind this depreciation pressure on their currencies. And they will probably end up with other unintended consequences: a deterioration of fiscal accounts to cover losses from FX swaps and dreaded sovereign ratings downgrades, which would attract even lower capital flows to cover the deficit on the current account. In other words, such FX interventions would be feasible in smoothing the moves due to short-term speculative positioning and buy time to address the fundamental issues. For the longer term, we will hear more about the external vulnerabilities, as tightening in global liquidity conditions is a question of "when" rather than "if." Consequently, countries resorting to measures that simply delay the potential adjustment run the risk of a significant hit on fiscal balances, if they are eventually forced to let the currencies depreciate. In this case, instead of reaping the rewards of depreciation (see our piece "Embrace devaluation"), those countries will struggle with the effects of lower credit quality. While this comparison might be far-fetched at the moment, it is precisely what led to a decline in growth rates in CEE economies after the 2008/2009 crisis - because of the inability to let the currency weaken when it necessary. It is too early to make a prediction, but judging by the recent behaviour of their central banks, Brazil, Turkey, India and Indonesia might already be declining. Related links: FX swap lines to the rescue? - FT Alphaville More on that US dollar funding problem [updated] - FT Alphaville Basis swaps and beer - FT Alphaville On the matter of ECB swap lines... - FT Alphaville