Definition: Currency swap agreements involve two central banks exchanging currencies at a fixed exchange rate. It functions as a credit line from one country to another, providing flexibility in managing currency reserves.
Components:
- The borrowing central bank sells its domestic currency to the lending central bank, receiving a hard foreign currency at the prevailing market exchange rate.
- The borrowing central bank commits to buying back its currency at the same exchange rate on a specified future date.
India’s Currency Swap Agreements:
- India-Japan Currency Swap (2018):
- This agreement allows the RBI to draw up to $75 billion worth of yen or dollars from the Japanese government, providing flexibility in managing external account stability and forex reserves.
- India-UAE Currency Swap (2018):
- A currency swap agreement with the UAE worth $500 million enables both countries to settle trade transactions in their respective national currencies, reducing dependence on third-party currencies.
- SAARC Currency Swap Arrangement:
- India has a Currency Swap Arrangement for SAARC Member Countries with a standby amount of $400 million, operated within an overall facility size of $2 billion.
These currency swap agreements enhance financial stability, signal stability to investors, and reduce dependence on third-party currencies in trade transactions. They contribute to the internationalization of the Indian rupee.
Rupee Depreciation in 2020: Case Study
The depreciation of the Indian rupee against the US dollar in 2020, hitting a historic low of nearly Rs.77 for a US dollar in April, can be attributed to a combination of global and domestic factors:
Global Reasons:
- Global Economic Contraction:
- The outbreak of the global pandemic led to economic contractions worldwide. The resulting uncertainty and economic downturn led to a decline in optimism about the global and Indian economies. Investors sought safe-haven assets, including the US Dollar, leading to capital flight from other currencies, including the rupee.
- US-China Trade Tensions:
- Escalating trade tensions between the United States and China added to the global economic uncertainty. Investors sought refuge in the US Dollar, considering it a safer asset during periods of geopolitical tensions.
- Crash in Global Crude Prices:
- The crash in global crude oil prices had a significant impact. Speculative capital moved towards the US Dollar as a safe haven. Foreign institutional investors (FIIs) sold off rupee holdings and converted them into dollars.
- Expectations of Future Depreciation:
- Investors anticipated further depreciation of the rupee in the future. This expectation prompted them to sell off rupees at the prevailing exchange rates, fearing that it might become costlier to do so in the future.
Government Measures:
To address the fall in the rupee’s value, the government took corrective measures, including the liberalization of External Commercial Borrowings (ECBs) and Foreign Portfolio Investments (FPI). These measures aimed to attract foreign capital and stabilize the exchange rate.
FAQs
Q: What is a Currency Swap Agreement?
A Currency Swap Agreement is a financial contract between two parties to exchange a series of cash flows in different currencies. These agreements are often used to hedge against currency exchange rate risks or to obtain cheaper financing in foreign currencies.
Q: How do Currency Swap Agreements Work?
In a currency swap, two parties exchange principal and interest payments on a loan denominated in one currency for equivalent amounts in another currency. Typically, one party borrows in its domestic currency and lends in the foreign currency, while the other party does the opposite. The exchange rates and terms are agreed upon at the beginning of the contract.
Q: What are the Benefits of Currency Swap Agreements?
Currency swap agreements offer several benefits, including:
- Hedging against exchange rate fluctuations, reducing currency risk exposure.
- Accessing cheaper financing in foreign currencies compared to domestic markets.
- Managing cash flows more efficiently, especially for multinational corporations operating in multiple countries.
- Facilitating international trade by providing certainty in currency exchange rates over a specified period.
Q: Who Uses Currency Swap Agreements?
Currency swaps are commonly used by multinational corporations, financial institutions, and governments. Multinational corporations use them to manage currency risks associated with international operations, while financial institutions utilize them for arbitrage opportunities and liquidity management. Governments may employ currency swaps to stabilize exchange rates or obtain foreign currency reserves.
Q: What are the Risks Associated with Currency Swap Agreements?
While currency swaps can provide benefits, they also come with risks, including:
- Exchange rate risk: Fluctuations in exchange rates can affect the value of cash flows exchanged in the swap.
- Credit risk: There’s a risk that one party may default on its obligations, leading to financial losses for the other party.
- Regulatory risk: Changes in regulations or government policies can impact the terms and legality of currency swap agreements.
- Liquidity risk: Difficulty in finding counterparties or exiting swap agreements can pose liquidity challenges, especially during times of market stress.
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