India is currently coordinating with the United States to secure a dollar currency swap line. This arrangement would serve as an additional safety net in case of any sudden outflow of funds. It’s worth noting that India already has similar arrangements with other central banks, like those of Japan and the UAE.
Reason for the Swap: Economic Impact of COVID-19
The ongoing economic turmoil due to the COVID-19 pandemic has had a significant effect on investor sentiment. Foreign institutional investors (FIIs) have turned into large scale sellers of Indian equity and debt markets in March and April. Consequently, a substantial outflow of funds from the country has been observed.
In an effort to stabilize the rupee, which recently plummeted below the 76 level against the dollar, India liquidated its forex assets. Forex assets are resources held by a central bank in foreign currencies and can include foreign currencies, bonds, treasury bills and other government securities. Central banks hold these assets as a contingency plan in case the national currency rapidly devalues.
Changes in India’s Forex Assets
According to data from the Reserve Bank of India (RBI), India’s forex assets witnessed a decrease of around $7.50 billion within a span of two weeks, amounting to $439.66 billion as of March 27. The RBI data also indicates that 63.7% of India’s forex assets, equivalent to $256.17 billion, is invested in overseas securities, primarily in the US treasury.
Despite the continued outflows of funds from the markets, India is expected to comfortably navigate through these challenges, thanks to the sufficiency of foreign exchange reserves. However, a swap line with the US Federal Reserve offers an additional cushion to the forex markets.
Understanding Dollar Swap
A dollar swap is a type of currency swap, where ‘swap’ stands for exchange. In this arrangement, two countries agree to exchange currencies based on pre-determined terms and conditions.
In a dollar swap arrangement, the US Federal Reserve provides dollars to a foreign central bank. Simultaneously, the foreign central bank gives an equivalent amount of funds in its own currency to the Federal Reserve. This is based on the market exchange rate at the time of the transaction. The two parties then agree to swap back these amounts of their respective currencies at a specified date in the future, which could be as soon as the next day or up to three months later. These transactions are conducted at the same exchange rate as in the initial transaction.
As the transaction terms are set in advance, these swap operations carry no exchange rate or other market risks. Central banks and governments typically engage in currency swaps with foreign counterparts to meet short-term foreign exchange liquidity requirements or to guarantee an adequate amount of foreign currency. This aims to prevent potential Balance of Payments (BOP) crisis until longer-term arrangements can be made.