Context: The Central Bank of Sri Lanka (CBSL) settled a $400 million currency swap facility from the Reserve Bank (RBI) of India last week, meeting the terms that the two countries had agreed upon.
- Of the many economic side effects of the global pandemic, is the drastic fall in Sri Lanka’s foreign exchange reserves — driven mainly by exports, remittances and tourism that have all suffered heavily post COVID-19
- The Central Bank of Sri Lanka had sought a $400 million currency swap with the Reserve Bank of India (RBI), to boost its foreign reserves.
- Sri Lanka has resorted to the currency swap facility with the RBI from time to time to maintain its reserves.
What is a Currency Swap?
- A currency swap is a transaction in which two parties exchange an equivalent amount of money with each other but in different currencies.
- The parties are essentially loaning each other money and will repay the amounts at a specified date and exchange rate.
- The purpose could be to hedge exposure to exchange-rate risk or to reduce the cost of borrowing in a foreign currency.
- Currency Swaps are used to obtain foreign currency loans at a better interest rate than could be obtained by borrowing directly in a foreign market.
- Central banks and Governments engage in currency swaps with foreign counterparts to meet short term foreign exchange liquidity requirements or to ensure adequate foreign currency to avoid Balance of Payments (BOP) crisis till longer arrangements can be made.
- In the swap arrangement, a host nation provides dollars or any other currency agreed upon to a foreign central bank, which, at the same time, provides the equivalent funds in its home currency to the former, 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 two years later, using the same exchange rate as in the first transaction.
RBI and Swap Agreements with other nations
- The RBI also offers similar swap lines to central banks in the SAARC region within a total corpus of $2 billion.
- India already has a bilateral currency swap line with Japan, which has the second highest dollar reserves after China.
- These swap operations carry no exchange rate or other market risks, as transaction terms are set in advance.
- The absence of an exchange rate risk (Meaning exchange is fixed in advance for the total time period and is not subject to any volatility) is the major benefit of such a facility.
- This facility provides the country, which is getting the dollars, 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.
Framework on Currency Swap Arrangement for SAARC countries
- To further financial stability and economic cooperation within the SAARC region, the Reserve Bank of India has put in place a revised Framework on Currency Swap Arrangement for SAARC countries 2019-2022.
- The Framework is valid from November 14, 2019 to November 13, 2022.
- Based on the terms and conditions of the Framework, the RBI would enter into bilateral swap agreements with SAARC central banks, who want to avail swap facility.
- SAARC Currency Swap Facility came into operation with an intention to provide a backstop line of funding for short term foreign exchange liquidity requirements or balance of payment crises till longer term arrangements are made.
- Under the Framework for 2019-22, RBI will continue to offer swap arrangement within the overall corpus of US $ Two billion.
- The drawals can be made in US Dollar, Euro or Indian Rupee. The Framework provides certain concessions for swap drawals in Indian Rupee.
- The Currency Swap Facility will be available to all SAARC member countries, subject to their signing the bilateral swap agreements.