How will the currency swap agreement between India and Japan work?

India and Japan on Monday inked a bilateral currency swap agreement to the tune of $75 billion. Indivjal Dhasmana explains how it will work

How will the currency swap between India and Japan work?

It is an emergency provision and while India has had similar agreements before, it has never had to resort to it. The agreement offers some comfort to the country facing rupee and current account deficit woes. The swap agreement implies that India can take up to $75 billion from Japan in exchange of the rupee as and when the need arises. Japan can also do the same in exchange of the Yen. The agreement would be implemented by the Reserve Bank of India and the Bank of Japan.  

The agreement entails another aspect — the use of local currencies for trade and infrastructure development needs. The two currencies are hedged to avoid the risk of fluctuations in their values. However, this time around mandatory hedging may be done away with.

Why did the government of India feel the need for such an agreement at this point in time?

India felt the need for the swap because it is facing steady depreciation of the rupee against the dollar and widening current account deficit (CAD). The rupee fell 16 paise to 73.61 against the US dollar in early trade on Tuesday. The trade deficit, which is the biggest part of CAD, declined to $13.98 billion in September. It had stood at $17.4 billion in August and $18.2 billion in July. However, trade deficit cumulatively widened to $49.58 billion in the second quarter of the current financial year, higher than almost $45 billion in the first quarter of the current financial year. As such, CAD will definitely come under pressure now, with economists forecasting it at 3 per cent of the GDP in the current financial year. 

To finance the CAD, India needs capital inflows. At the current level of forex reserves at $394 billion, capital resources are not a concern, but if the forex reserve is depleted even marginally due to higher CAD, it will become an issue. This is a possibility with foreign portfolio investors selling equities in the Indian markets. 

Is this the first such agreement of its kind?

No, but this time around the circumstances are different. The agreement will come in handy to finance trade and infrastructure needs in local currencies, instead of forcing the use of the dollar. India had first signed a currency swap agreement with Japan in 2008, but it was limited to $3 billion. The two countries reviewed it first in 2011 and then in 2013, increased the size to $15 billion and $50 billion respectively. Now it has been raised to $75 billion.

How is the latest currency swap announcement different from the currency swap announced in 2013 by then Reserve Bank of India governor Raghuram Rajan to deal with the CAD crisis?

The currency swap announced in 2013 was for non-resident Indians and not restricted to any country. The RBI had opened a window to the banks to swap some FCNR (B) [Foreign Currency Non-Resident (Bank) Account] dollar funds, mobilised for a minimum tenor of three years and above, at a fixed rate of 3.5 per cent per annum.  

Does any other country have a similar agreement with Japan?

Yes. Earlier this month, Japan and China entered into similar agreement to the tune of $28.80 billion. The agreement is aimed to advance regional trade by enhancing the share of regional currencies in the trade. So far, the US dollar has dominated the trade scene in the far east. This has made the trade vulnerable to dollar-yen and dollar-renminbi fluctuations. These risks, it is hoped, would be reduced by this agreement. 

What sort of signal will this agreement give the markets?

The agreement gives the signal that India has a provision to tackle the rupee volatility and its CAD problems. Also, it increases the chances of Indian entities to be able to borrow overseas at a lesser cost. As such, it provides stability to forex and the capital markets.