Can Currency Swap Change the Game in Regional Economic Dynamics?

Jul 27 , 2024
By Tesfaye B. Lelissa (PhD)

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Ethiopia and the UAE have signed an unprecedented currency swap agreement. The groundbreaking deal is set to redefine economic ties between East Africa and the Middle East, opening up new avenues for financial integration. The countries aim to streamline trade, cut transaction costs, and address exchange rate risks by swapping their local currencies. The theory of comparative advantage is at play here, with each country leveraging its strengths to bolster mutual growth, writes Tesfaye Boru Lelissa (PhD) (teskgbl@gmail.com).

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The central banks of Ethiopia and the United Arab Emirates (UAE) have recently established a groundbreaking currency swap agreement, promising to reshape the economic relationships between East Africa and the Middle East. The deal prescribes a nominal value cap of up to three billion Durham (approximately 817 million dollars) and 46 billion Br, marking a pioneering step toward financial integration between the two countries.

The UAE Central Bank and the National Bank of Ethiopia (NBE) also focus on harmonising payment platforms and exploring digital currencies, further strengthening their economic ties.

A currency swap involves the exchange of payments in different currencies between two parties over a predetermined period. Grounded in the theory of comparative advantage developed by economist David Ricardo, this arrangement allows countries to optimise their economic output by specialising in producing goods and services with a comparative advantage and engaging in trade to obtain other goods and services. In this context, the currency swap enables the mutual exchange of local currencies, allowing each country to access the currency it needs more efficiently and at a lower cost.

However, the benefits of this currency swap agreement extend beyond mere currency exchange. It helps address exchange rate fluctuations, a critical concern for businesses and investors engaged in cross-border activities. Introducing a new asset — the swap arrangement — can alter the demand for and supply of different currencies, leading to more stable exchange rates, as suggested by the portfolio balance theory.

The swap can facilitate trade and investment ties between Ethiopia and the UAE by reducing transaction costs and exchange rate risks, encouraging greater participation in bilateral economic activities. Implementing a currency swap agreement can draw insights from the extensive literature on regional monetary cooperation, which shows that such arrangements can strengthen economic and financial integration, promote policy coordination, and enhance resilience to external shocks. This conforms to the theory of optimum currency areas, which suggests that adopting a common currency or establishing currency-pegging arrangements can yield substantial benefits for countries with strong economic ties.

Beyond the currency swap, the central banks of Ethiopia and the UAE aim for deeper financial integration through the harmonisation of payment platforms and joint exploration of digital currencies. Integrating the UAE's UAESWITCH and Ethiopia's ETHSWITCH instant payment systems, national card switches, and messaging platforms will create a more efficient and secure digital payment ecosystem. The initiative demonstrates the shared commitment of both countries to harness the transformative power of financial technology and central bank digital currencies (CBDCs).

By aligning their digital payment systems and pioneering innovative fintech solutions, Ethiopia and the UAE are sailing to redefine the rules of engagement in the regional and global financial ecosystem.

However, the currency swap agreement faces potential issues that should be addressed.

The experiences of other countries, such as the China-Japan and India-Japan currency swap agreements, offer valuable lessons for Ethiopia and the UAE. In both cases, the central banks and regulators faced problems maintaining the appropriate swap size as economic conditions and bilateral priorities evolved. Ethiopia and the UAE should carefully assess factors such as the volume of bilateral trade, investment flows, and potential for future growth to determine the optimal swap size that can effectively support their economic and financial cooperation.

The nominal value thresholds currently set should be reviewed and adjusted over time as the economic relationship between them evolves. This would allow the central banks to adapt to changing market conditions and growing financial and trade linkages.

Ethiopia and the UAE will need to make a crucial decision about the exchange rate mechanism, whether fixed or floating. This decision can align with both countries' broader monetary and financial policies, ensuring coherence and stability. The China-Japan and India-Japan currency swap arrangements have faced problems, illustrating the need for close coordination between their central banks. Extensive bilateral dialogues will be necessary to harmonise exchange rate policies and monetary policy frameworks, facilitating seamless integration of the currency swap agreement.

Regulatory harmonisation and clear operational guidelines will be essential for successfully implementing the agreement. This may involve addressing issues related to capital controls, foreign exchange regulations and integrating the swap facilities with existing payment and settlement systems. Drawing on the experiences of other countries, they can work closely to make their regulatory frameworks compatible, ensuring a coherent and transparent environment for the currency swap arrangement to thrive.

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PUBLISHED ON Jul 27,2024 [ VOL 25 , NO 1265]

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