Currency swap facility for Sri Lanka "EMPOWER IAS"

In news:

• The RBI has agreed to a $400 million currency swap facility for Sri Lanka till November 2022.

 

 

Why such move by RBI?

• The RBI’s action follows a recent bilateral ‘technical discussion’ on rescheduling Colombo’s outstanding debt repayment to India.
• Following the outbreak of COVID-19 in the region, India had proposed a virtual meeting to discuss the request. Sri Lanka owes $960 million to India.
• In turn, Sri Lanka would facilitate, protect and promote a liberal ecosystem for Indian investors.

 

What is a Currency Swap Agreement?

• The currency swap agreement is an agreement to exchange currency between two foreign parties.
• In fact, all the agreement which consists of generally swapping principal and also interest payments on a loan made in one currency, for principal and interest payments of a loan of equal value in another currency.
• In simple terms, it is an open-ended credit line from one country to another at a fixed exchange rate. The country which avails itself of this loan pays interest to the country which provides it, at a much lower benchmark interest rate.

 

Advantages of Currency Swap Agreement

• The main purpose of engaging in a currency swap is usually to procure some loans in foreign currency at more favourable interest rates than if borrowing directly in a foreign market.
• It can help to reduce exposure to anticipated fluctuations in exchange rates.

 

What is the purpose of currency swap?

• To avoid turbulence and other risks in the foreign exchange market and exchange rate.
• Often, the turbulence comes when a country faces scarcity of foreign currency which may lead to currency crisis and steep depreciation of the domestic currency. In such a scenario, if the central bank/ government (read the RBI/Government) are able to get sizable foreign currency by exchanging domestic currency, it ensures availability of foreign currency.
• Besides currency or exchange rate stability, currency swaps between governments also have supplementary objectives like promotion of bilateral trade, maintaining the value of foreign exchange reserves with the central bank and ensuring financial stability (protecting the health of the banking system).
• Currency swap agreement can be bilateral or multilateral.
• Usually, currency swap agreements are of five types depending upon the nature and the status of the currencies swapped.
  1. Exchange cash for cash vs cash for securities;
  2. Exchange conditional vs unconditional swaps;
  3. Exchange reserve currencies on both sides;
  4. Exchange reserve currency for non-reserve currency; and
  5. Exchange non-reserve currencies on both sides.
• India and Japan have signed a currency swap agreement during the visit of Prime Minister Modi to Japan on 28th of October 2018.
• The currency swap agreement is for US $75 bn and is a great opportunity for India to obtain foreign currency by exchanging rupee to Japan.
• According to the initial reports, the swap involves US Dollar besides Japanese Yen and Indian Rupee. As part of the agreement, the Bank of Japan (Japanese central bank) will accept rupees and give dollars to the Reserve Bank of India (RBI) and, similarly, the RBI will take the yen and give dollars to the Bank of Japan to stabilize each other’s currency.

 

How does it work?

• In a swap arrangement, RBI would provide dollars to a Lankan central bank, which, at the same time, provides the equivalent funds in its currency to the RBI, based on the market exchange rate at the time of the transaction.
• The parties agree to swap back these quantities of their two currencies at a specified date in the future, which could be the next day or even three months later, using the same exchange rate as in the first transaction.

 

Benefits of currency swap

• The absence of an exchange rate risk is the major benefit of such a facility.
• This facility provides the flexibility to use these reserves at any time in order to maintain an appropriate level of balance of payments or short-term liquidity.
• Swaps agreements between governments also have supplementary objectives like the promotion of bilateral trade, maintaining the value of foreign exchange reserves with the central bank and ensuring financial stability (protecting the health of the banking system).