India has extended the duration of a $400 million currency swap facility with Sri Lanka which it had concluded with the island nation in January this year.

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).

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