Earlier last week, while Western nations were brainstorming ideas to end the European crisis at the G20 meeting, BRICSs (Brazil, Russia, India, China, South Africa) leaders converged to come up with some economic programs of their own. By the end of the week, the emerging powerhouse nations of China and Brazil agreed to a 10-year currency swap deal worth up to 30 billion USD.
First of all, what the heck is a currency swap deal?
Traditionally, a currency swap involves the exchange of a principal amount, with each counterparty making periodic interest payments based on their own respective interest rates. At the end of the deal, both parties will then swap back the notional principals. This is done to help hedge and minimize risks due to currency fluctuations.
However, the currency swap deal between China and Brazil is of a different variety, although the intended effect is also aimed at limiting market risks.
According to Brazilian Finance Minister Guido Mantega, the Chinese-Brazilian currency swap agreement will be allowed to call up the other's central bank and swap as much as 30 billion USD worth of Chinese yuan and Brazilian reals. This will allow both nations to boost national reserves in times of financial turmoil and should help free up liquidity if and when capital markets dry up.
Take note that China is already Brazil's largest trade partner, accounting for 17% of Brazil's total trade. The agreement should help foster more cooperation and trade between the two nations, as it allows trade channels to flow smoothly regardless if the global economy takes a hit.
The truth is that this is nothing new for China. Over the past four years, China has made similar currency swap agreements with other nations such as Australia, the UAE, and Hong Kong.
The purpose of all these agreements? To promote the yuan as a reserve currency, of course!
It's no secret that China has been pushing for the yuan to be used in global transactions. Not only would this bring down transaction costs, but it would also allow the yuan to be more smoothly integrated into the global economy. This in turn would cause other nations to starting adjusting their reserve portfolios and allocating a larger portion to the yuan, cementing China's place as a global power.
Looking ahead, I don't think we've heard the last of China making currency swaps with other nations. With all the concerns about stability of the global economy and the fragility of the dollar - the world's reserve currency - don't be surprised if you see deals between China and other larger economies as central banks aim to minimize risk and diversify their holdings.