What is currency swap agreement?

What is currency swap agreement?

♦Meaning of currency swap agreement

  • The word swap implies exchange. A currency swap between two nations is a contract or agreement to exchange currency (of the two nations or any hard currency) with predetermined terms and conditions.
  • Generally, the mainstream type of currency swap is between two central banks. Here, the main purpose behind currency swap by a central bank like the RBI is to get the foreign currency from the issuing foreign central bank at the predetermined conditions (like swapping rate and the volume of cash) for the swap. Other than supporting the domestic currency and foreign exchange market, another main reason for currency swap is to keep the estimation of the foreign exchange reserves kept with the central bank.

♦Purpose of currency swap

The main purpose of currency swaps is to avoid disturbance and other risks in the foreign exchange market and exchange rate.

  • Central banks and governments take part in currency swaps with foreign counterparts to guarantee sufficient foreign currency during the time of foreign currency shortage. The two works with a similar objective and through similar mechanism.
  • Often, the disturbance comes when a country faces shortage of foreign currency which may lead to currency crisis and steep devaluation of the domestic currency. In such a situation, if the central bank/ government (read the RBI/Government) is able to get sizable foreign currency by exchanging domestic currency, it guarantees availability of foreign currency. Hence the disturbance in the foreign exchange market or devaluation of the domestic currency/currency crisis can be avoided.
  • Currency swaps between governments also have secondary objectives (other than currency or exchange rate stability) 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).
  • It is always desirable for a developing country like India to reach currency swap agreement with countries like USA/UK/EU/Japan whose currencies are hard currencies (used in international trade as medium of exchange).
  • Currency swap agreement can be bilateral or multilateral.

Note: Currency swap between U.S. Federal Reserve and the Central Bank of France was the very first currency swap which was signed on February 28, 1962.

♦Types of Currency Swap agreement

Depending upon the nature and the status of the currencies swapped, currency swap agreements are usually of 5 types:

  •  Exchange cash for cash vs cash for securities;
  • Exchange conditional vs unconditional swaps;
  • Exchange reserve currencies on both sides;
  • Exchange reserve currency for non-reserve currency; and
  • Exchange non-reserve currencies on both sides.

♦How will the currency swap agreement help?

Example: Amid the worldwide pandemic as the pressure on Indian currency is increasing, RBI expressed for a currency swap agreement with the US Federal Reserve.

The US Federal Reserve’s grant will help India in stabilizing markets, reduce volatility and ease pressure on the Indian rupee.

According to RBI, India’s foreign exchange reserves have fallen by nearly $13 billion. On March 6, India has a foreign exchange reserve of $487.23 billion which fell to $474.66 billion on April 3.

On March 19, the currency swap agreements with other central banks of the world to contain the risk of the shortage of dollars in global markets was announced by the US Federal Reserve. However, at the time India was excluded from the list.

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