Tuesday, September 10, 2013

Recently, the government announced that it has formed a task force to explore the possibility of a currency swap agreement for trade purposes. 

The task force consisting of representatives from the Ministry, Department of Economic Affairs, Reserve Bank of India (RBI), SBI, industry bodies FICCI, CII and Federation of Indian Exporters Organisation (FIEO) will look at the possibility of trading in local currency and advise on its advantages and disadvantages. It has also been clarified that the proposed agreement will be different from the current currency swap agreement of the central banks.

What is currency swap?
  • Currency swaps were invented in 1970s to bypass capital controls prevalent in various parts of the world. 
  • Here’s what they basically are. 
1.   Let’s say, company 'A' needed to borrow in US dollars but was not allowed to do so in its home country, say, India. 
2.   At the same time, a US company wants to increase its investment in India. 
3.   Now the Indian company will borrow in rupees and lend to the US company in India, while the US company will borrow in dollars and lend it to the Indian company in the US.

There is a lot of innovation that has happened since. 

For example, companies now hedge their future cash flow in foreign currency by entering into currency swap contracts. Debt and interest payments are also hedged through currency swaps.

The present plan
  • Currently, the government of India is exploring options of trading in the Indian rupee with large trading partners. 
  • If Indian importers are able to settle bills in rupees, it will lessen demand for dollars and will reduce the pressure on the rupee in the currency market. 
  • Trading partners that accept rupee will use it for importing goods from India. 
  • However, how far will such measures help stabilize the rupee is debatable. For example, what will be the incentive for our trading partners for entering into such an agreement? 
  • Also, since India runs a large deficit on the current account, the impact on the total demand for foreign currency could be minimal.

Swap agreements of central banks
  • The government has clarified that what they intend to do will be different from existing agreements of central banks. 
  • Central banks swap their currency for a specified period. 
  • For example, since most of the global trade happens in US dollars, the Federal Reserve provides a dollar liquidity swap line to other central banks. 
  • Under this facility, the Federal Reserve enters into an agreement with a foreign central bank to buy its currency at the existing exchange rate. 
  • However, the foreign central bank will have to buy back its own currency from the Federal Reserve at a specified date, but at the exchange rate used in the first transaction. 
  • This helps central banks to address temporary dollar liquidity crunch in their respective countries.

  • Currency swap has emerged as an important derivative tool after the global financial crisis of 2008 to hedge the exchange rate risks. 
  • India has signed currency swap agreements with Japan ($15 billion) and Bhutan ($100 million). 
  • China has shown active interest in entering into such an agreement with India, but it is yet to be signed.

The inter-departmental group of the Commerce Ministry will also have representation from Export Credit Guarantee Corporation of India. It would explore the possibility of using local currency for trade with major trading partners and advice on pros and cons of the same, it added.

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