Capital Markets: Challenges and Developments

How a dollar swap line with US Fed can help in uncertain times?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Currency Swap

Mains level : Currency Swap and its significance

India is working with the US to secure a dollar swap line that would help in better management of its external account and provide an extra cushion in the event of an abrupt outflow of funds.

What are Currency Swaps?

  • A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies.
  • The purpose of a currency swap is to lower exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.

Why do we need dollars?

  • According to RBI data, 63.7% of India’s foreign currency assets — or $256.17 billion — are held in overseas securities, mainly in the US treasury.
  • While FPIs investors looking for safer investments, the current global uncertainty over COVID outbreak have led to a shortfall in Indian stock markets.
  • This has pulled down India’s foreign exchange reserves.
  • This means that the government and the RBI cannot lower their guard on the management of the economy and the external account.

How does a swap facility work?

  • In a swap arrangement, the US Fed provides dollars to a foreign central bank, which, at the same time, provides the equivalent funds in its currency to the Fed, 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.
  • These swap operations carry no exchange rate or other market risks, as transaction terms are set in advance.

Benefits of currency swap

  • The absence of an exchange rate risk is the major benefit of such a facility.
  • This facility provides India with the flexibility to use these reserves at any time in order to maintain an appropriate level of balance of payments or short-term liquidity.
  • 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).

Recent examples

  • India already has a $75 billion bilateral currency swap line with Japan, which has the second-highest dollar reserves after China.
  • The RBI also offers similar swap lines to central banks in the SAARC region within a total corpus of $2 billion.

Note: Relate all other terminologies related to USD-INR convertiblity viz. Current Account, BoP etc.

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