In May 2018, Japan resumed its bilateral currency swap line with China. The line was originally launched in 2002 although it had been suspended in 2013 due to increased political tensions over the Senkaku/Diaoyu Islands. China seems to be re-positioning diplomatically towards neighbouring countries under the intensifying pressure of a potential trade war with the United States.

Bilateral currency swap lines, unlike measures to mitigate balance of payment and liquidity crises, mainly aim to facilitate trade and investment. They serve in essence as a ‘credit line’ at a predetermined exchange rate. Currently, the Japanese Ministry of Finance has bilateral currency swaps with central banks in Indonesia, the Philippines, Singapore and Thailand, which are based on the framework laid by the Chiang Mai Initiative. Japan is also expected to conclude another swap arrangement with Malaysia. In the past, Japan had swaps with South Korea and India but these have been suspended or expired.

The Bank of Japan also has six central bank liquidity swap arrangements with the central banks of the United States, the European Union, the United Kingdom, Switzerland, Canada and Australia. The arrangements with the first five central banks have no limits on amounts and time periods, but the arrangement with the Reserve Bank of Australia was limited to AUD$20 billion (US$14 billion) and is effective only until March 2019.

Bilateral currency swap lines are different from the central bank liquidity swap lines extended by the US Federal Reserve, which basically involve a ‘repo transaction’ at the prevailing exchange rate. The Bank of Japan obtains US dollars through the central bank liquidity swap line, which allows it to provide dollar liquidity to private banks through market operations. The Bank of Japan must eventually buy back the yen sold to the Federal Reserve.

Japan has concluded three bilateral currency swap arrangements with South Korea, which have all been terminated or expired. The first bilateral swap arrangement was launched in July 2001 within the framework of the Chiang Mai Initiative. The swap was a unilateral transfer of funds amounting to US$2 billion from Japan to South Korea, using the US dollar and the South Korean won. The fund was eventually transformed into a reciprocal arrangement and expanded to US$10 billion, but was terminated in February 2015 as the diplomatic relationship deteriorated due to historical grievances and territorial disputes over the Dokdo/Takeshima Islands. By then, both the second and third arrangements had already expired.

For South Korea, facing a currency crisis during the global financial crisis there was a delicate policy issue revolving around the choice between a number of financial safety nets. South Korea could have relied on the resources of the International monetary Fund (IMF) despite the ‘IMF stigma’, a regional safety net such as the Chiang Mai Initiative Multilateralization (CMIM), the central bank liquidity swap line or bilateral currency swap lines. After South Korea’s central bank swap line with the Federal Reserve was so effective in stopping the won’s depreciation, the country made repeated requests for the central bank swap arrangement to become permanent. Although, the Federal Reserve terminated the line in February 2010, it was reintroduced in May 2010, resulting in a network of swaps among six central banks(the Bank of Canada, European Central Bank, Bank of Japan, Federal Reserve and Swiss National Bank) in 2011.

Looking to the future, Japan will widen the scope of its bilateral swap arrangements with Asia-Pacific countries, in view of expanding the CMIM both in terms of the number of member countries and the active use of ample foreign reserves. This may serve to prevent the spillover of negative financial shocks and minimise losses arising from next financial crisis.

Meanwhile, the People’s Bank of China intends to employ currency swaps as an important instrument for internationalising the renminbi. Trade settlement and payment in renminbi has surged, in part due to China’s bilateral currency swap arrangements with 32 countries.

China’s currency swaps have also been used to bail out countries in financial crisis. In 2014, Argentina drew upon its currency swap line with China to mitigate a dollar liquidity shortage. The line was employed as a substitute for the central bank liquidity swap arrangement with the Federal Reserve. The yuan obtained through the currency swap arrangement with China could be converted into dollars on the offshore renminbi market, even though the renminbi is not fully convertible on capital account transactions.

The case of Argentina may suggest that if the renminbi depreciates, partner countries will be prompted to use their currency swap arrangements with China to obtain dollar liquidity. This will cause the renminbi to be sold off against the US dollar, thereby undermining the strategy of internationalising the renminbi using bilateral currency swaps and offshore markets. And this may aggravate the risk of financial crisis in China.

Kazumasa Iwata is President of the Japan Center for Economic Research and Emeritus Professor at the University of Tokyo.