What is a currency swap?

Understanding currency swaps

In its bid to help the developing countries, the Indian government may soon allow currency swaps backed by mineral resources. A currency swap is an agreement between two cross-border entities where one of them agrees to provide a loan to another in a foreign currency. The repayment takes place in a different currency at a fixed date and an exchange rate. The interest rate charged on such loans is usually lesser than that available in the foreign market.

Let us understand it with an example. Suppose India signs a currency swap agreement worth $5 million with say, Nepal. India will then provide a loan to Nepal in a foreign currency which may be US Dollar. In return, Nepal will have to return the money in Indian Rupees at a fixed interest rate.

This comes as a saviour for the countries going through a foreign reserve crisis as it allows them to get a loan in USD, at a lower rate of interest.

Sri Lanka crisis and India’s lending hand

Sri Lanka has been going through severe economic and political turmoil for the last several months now. High inflation and depletion of foreign reserves to an unsustainable level led the country to utter chaos.

To help the neighbour, India signed a currency swap agreement of $400 million with Sri Lanka. And in April, extended its term for repayment after the country said that it cannot meet its debt obligations. Since 2018, India has agreed to sign currency swaps with 23 countries.

Why do countries opt for currency swaps?

These swaps allow the countries to get a loan at a lower rate of interest than the foreign markets. Also, it helps the recipient country to maintain their foreign reserves even as other foreign debt obligations loom large.

How are exchange rates determined?

The exchange rates of currencies keep changing every day. This may lead to inconvenience at the time of repayment. For this, the exchange rate is usually fixed in advance during the signing of the agreement. So, the repayment amount remains largely the same.

With the government mulling over backing the currency swaps with trade, we may see India extending more such agreements to developing countries.