Currency swap agreement between India and Japan

•  Japan and India have entered into a $75-billion currency swap arrangement that will bolster the country’s firepower as it battles a steep drop in the rupee’s value.
• The facility will serve as a second line of defence for the rupee after the $393.5 billion of foreign exchange reserves that the Reserve Bank of India (RBI) has at its disposal.

What is a currency swap?

• A currency swap is an agreement between two parties to exchange a series of cash flows denominated in one currency for those denominated in another for a predetermined period of time. This involves the swap of the currency amounts for an agreed period and payments of interest during that period.
• Unlike an interest rate swap, a currency swap requires the actual exchange of the two principal currency amounts on which the sets of cash flows are based.
• An exchange takes place at the beginning of the arrangement and at maturity the amounts are swapped back.
• This actual exchange of principal is an important feature of a currency swap because, although the two amounts exchanged at the beginning of the agreement may be of equivalent value in the market, it is unlikely (as a result of movements in the exchange rate) that this will be the case at maturity. This means there is a residual counterparty risk that remains after the currency swap has been agreed.

Analysis:

• The deal will help the two countries to swap their currencies for U.S. dollars to stabilise the rupee which has witnessed the steepest fall in recent years. The agreement will allow India to tap foreign capital as and when the need arises and help to bring down the cost of funds for Indian companies while accessing the foreign capital market.
• The currency swap agreement will have a positive impact on financing India’s current account deficit.
• This comes against the backdrop of a gradual increase in interest rates in the U.S. that has led to the strengthening of the greenback against other currencies, and flight of capital from emerging economies.

By: Vishal