Benefits of Foreign Exchange Swap and Why You Need to Know It?

Benefits of Foreign Exchange Swap and Why You Need to Know It?

13 Sep 2019 12:56 PM

Foreign exchange swap as the name depicts is a swap of foreign exchange. This swap is done between two countries and thus is a bilateral currency swap arrangement. It is also called as a cross-currency swap and serves the purpose of hedging exposure to Foreign Exchange Risk or reducing the borrowing cost a foreign currency.

What is a foreign exchange swap?

For a currency or a foreign exchange swap contract, the interest rates have to be established for an agreed amount at a common maturity for the exchange. It’s a foreign exchange transaction which involves exchange of both the principal and the interest in one currency in lieu of the other currency, wherein the interest rates are benchmarked to LIBOR. Thus it is similar to an interest rate swap but in this case the currency which is the principal is exchanged. As the exchange rate can change over the period of time, the currency swaps give the two countries the comfort of knowing the amount they have to pay and receive at the maturity. Thus they help in hedging the foreign currency risk.

The Reserve Bank of India (RBI) has the flexibility to manage liquidity through these swaps. It can either sell the exchanged currency to importers for their bills or foreign loans can be paid by the borrowers. They also have the option to increase the Forex Reserves which should control the depreciation of Rupee.

Advantages of swaps in foreign exchange markets

  • Improves liquidity conditions – as the exchange is between two nations, the problem of blocking dollars and then converting to destination currency is solved giving enough room for improving liquidity in the market.
  • Stabilizing Balance of payments – This in turn helps in stabilizing the balance of payments of the nation.
  • Breather during tough times – As the currency amount and rate is fixed prior, the foreign exchange swaps are more stable especially during recessionary market conditions.
  • Boost in forex reserves – Helps in increasing the forex reserves for a nation as both nations exchange dollars.

India’s foreign exchange swap contract with other countries

Indian has this forex swap arrangement between many Asian nations. With the South Asian Association for Regional Cooperation (SAARC) nations till mid November 2017, wherein RBI offered up to an overall amount of US Dollar 2 billion both in foreign currency and Indian Rupee of swap arrangement.

Both nations give dollars in place of other nation’s currency. So at the recent foreign exchange swap between India and Japan, the Japanese central bank – Bank of Japan (BoJ) will accept Rupees and give US Dollars to India’s central bank – Reserve Bank of India (RBI), while RBI will take Yen and give US Dollars to BoJ – this is to stabilize each other’s economies. Apparently the deal with Japan was amongst the highest in value at USD 75 billion. This may lead to appreciation in the local currency after it has become the victim of global trade war tweets. The Japanese economy has a good forex reserve of over USD 1,250 billion and thus dollar demand from India is quite unlikely to happen. Though the Japanese may seek investment deals at their terms from India in exchange.

In the past India has struck such foreign exchange swaps with UAE and Sri Lanka also. In 2017, UAE agreed to do a currency swap of USD 52 billion with a non-oil trade of USD 34 billion. RBI also agreed to provide Sri Lankan Central Bank an amount of USD 400 million to boost the forex reserves of Sri Lanka.

India in the past have has currency swap agreements with many countries especially with oil exporting nations like Algeria, Nigeria, Iran, Iraq, Venezuela, Saudi Arabia. Non-oil exporting countries like Russia, Australia, South Korea, Singapore, South Africa amongst others.

Locally, Rupee was seen appreciating all the way to 68.50 to the US Dollar, which probably prompted RBI to conduct foreign exchange swap for a 3 year tenor in March this year. This was to supply funds for a longer duration to the banks. This amount garnered through the auction would reflect in the foreign reserves for that period.

Swaps in Foreign exchange markets are important

For the agreement to achieve its goal, it’s essential for exporters to strictly give quotations in Rupee for trade. This will work in tandem to government’s efforts in procuring more foreign exchange swaps. The currency swaps help in reducing the shoring current account deficit. Thus these swaps in the Foreign Exchange Markets are important for any economy which wants mitigate risk of long term currency fluctuation.

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