India has confirmed a $400 million currency swap with Sri Lanka while deferring another $500 million due for settlement to the Asian Clearing Union (ACU).

What is the news?

• Sri Lanka is facing a severe dollar crunch that economists say might lead to a default on external debt and create a food shortage in the imports-reliant island nation.
• In this regard, the Reserve Bank of India has extended currency swap facilities of $900 million to Sri Lanka.

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.
• Currency swaps are used to obtain foreign currency loans at a better interest rate than could be got by borrowing directly in a foreign market.

Practice question for mains:

Q. What are Currency Swaps? Discuss the efficacy of Currency Swap Agreements for enhancing bilateral cooperation in Indian context.

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.
• These swap operations carry no exchange rate or other market risks, as transaction terms are set in advance.

Why does one need dollars?

• FPIs investors look for safer investments but the current global uncertainty over COVID outbreak has led to a shortfall everywhere in the global markets.
• This has pulled down foreign exchange reserves of many small and developing countries.
• This means that the government and the RBI cannot lower their guard on the management of the economy and the external account.

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).

Back2Basics: Asian Clearing Union (ACU)

• The ACU with headquarters in Tehran, Iran, was established on December 9, 1974, at the initiative of the United Nations Economic and Social Commission for Asia and the Pacific (ESCAP).
• The primary objective of ACU was to secure regional co-operation as regards the settlement of eligible monetary transactions among the members of the Union/
• It now aims to provide a system for clearing payments among the member countries on a multilateral basis.
• The unit of settlement of ACU transactions is a common unit of account of ACU, and the unit is equivalent to one USD, and the Asian Monetary Unit may be denominated as ACU dollars and Euro.

Must read:

[Burning Issue] India – Sri Lanka relations in recent times

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