This article has been written by Oishika Banerji of Amity Law School, Kolkata. This article provides a detailed analysis of the currency swap agreement in which two parties trade the principal and interest of a loan in one currency for the principal and interest in another currency.

This article has been published by Sneha Mahawar.

Introduction 

A currency swap is a “contract to exchange primary amounts in two distinct currencies at an agreed-upon future date at an agreed-upon conversion rate.” During the contract’s period, the party’s trade interest is computed on the principal amounts in an agreed-upon manner. A currency swap is a legally binding agreement between two parties to swap principal and interest rate obligations, or receipts, in different currencies. The transaction entails two counterparties exchanging precise amounts of two currencies at the outset and repaying them over time according to a predetermined formula that reflects both the interest payment and the principal amount amortisation. This article provides every kind of information associated with currency swap agreement and the concept of currency swap as a whole. 

What does currency swap mean

A swap is a contract between two parties to exchange cash flows with differing characteristics at predetermined future times or at predetermined periodic intervals. The swap is one of three key types of derivatives securities used in risk management, the others being forwards/ futures and options. Swaps, or interest rate swaps, are a type of swap in which all cash flows are exchanged in the same currency. A currency swap is a swap that involves the exchange of cash flows denominated in two currencies, but it also involves the exchange of principals. When all cash flows are denominated in the same currency, there is no need to swap principles.

Purpose of currency swap

The purpose of a currency swap is to obtain loans in foreign currency at lower interest rates than if the funds were borrowed straight from a foreign market. Currency swaps were originally adopted by the World Bank in 1981 in order to obtain German marks and Swiss francs. On loans with durations of up to ten years, this type of swap is possible. Currency swaps are different from interest rate swaps since they entail principal exchanges as well.

Types of currency swaps 

The following types of cross-currency swaps are generally used:

Fixed to fixed currency swap 

Swapping fixed interest payments on a loan in one currency for fixed interest payments on an identical loan in another currency is an example of this type of swap. The actual principal does not have to be changed. Although an alternative currency can sometimes be swapped at spot into the desired currency, the primary amounts are always re-exchanged when the swap matures.

Fixed to floating cross-currency swap

Fixed-rate liabilities in one currency are swapped for floating rate commitments in another currency in this type of swap. For example, fixed-rate US dollars can be exchanged for pounds at LIBOR (London Inter-bank rate) + variable rate.

Stages in currency swap 

The currency swaps involve an exchange of liabilities between currencies and are carried out in three stages provided hereunder: 

1. A spot principal exchange: This is included in the swap agreement since a comparable impact can be achieved utilising the spot foreign exchange market.
2. Interest payments continue to be exchanged over the life of the swap: This is equivalent to a series of forwarding foreign exchange contracts over the duration of the swap contract. Typically, the contract is fixed at the same exchange rate as the spot rate used at the beginning of the swap.
3. Principal re-exchange at maturity: The principal amount getting re-exchanged 

In a currency swap the principal sum is usually exchanged in one of the following manners:

1. In the beginning.
2. At a combination of start and end.
3. In the end.

What is a foreign currency swap

A foreign currency swap, commonly known as an FX swap, is an agreement between two foreign parties to exchange currencies. The agreement entails exchanging principal and interest payments on a loan in one currency for principal and interest payments on a loan in another currency of equal value. A party borrows currency from a third party while simultaneously lending that party another currency. During the term of a currency swap, each party continues to pay interest on the swapped principal amounts. When the swap is completed, principal amounts are re-exchanged at a predetermined rate (to avoid transaction risk) or the spot rate.

Types of foreign currency swap

Currency swaps are divided into two categories, namely:

1. The fixed-for-fixed currency exchange entails swapping one currency’s fixed interest payments for another’s fixed interest payments. 
2. Fixed interest payments in one currency are swapped for floating interest payments in another in the fixed-for-floating swap. The principal amount of the underlying loan is not exchanged in this form of a swap.

Examples of foreign currency swaps

Currency exchange is frequently used to get lower-cost debt. For example, European Company ‘A’ borrows $120 million from U.S. Company ‘B’ and lends 100 million euros to U.S. Company ‘B’ at the same time. The rate is based on a $1.2 spot rate, which is linked to the London Interbank Offered Rate (LIBOR). The agreement enables the most cost-effective borrowing.

Furthermore, some institutions employ currency swaps to decrease their exposure to expected exchange rate changes. If a U.S. Company ‘A’ and a Swiss Company ‘B’ want to acquire one another’s currencies (Swiss francs and USD, respectively), they can use a currency swap to decrease their respective exposures. Several developing countries with liquidity concerns were given the option of currency exchange for borrowing purposes by the Federal Reserve during the 2008 financial crisis.

What are interest rate swaps

A simple agreement between two parties to exchange a series of interest payments on an underlying loan is known as an interest rate swap. There is no exchange of principal, and an unrelated quiet financial transaction occurs that has no bearing on the lender. A fixed-rate of interest is replaced with a variable rate or vice versa. A legal agreement between two parties to exchange their interest rate obligations or receipts is known as an interest rate swap. As a result, interest payment streams of various kinds are swapped according to specified rules and are based on an underlying notional principal amount in such a transaction. 

Interest swaps provide a buffer against future interest rate changes as well as the introduction of new, low-cost borrowing options. When a corporation borrows to take advantage of one type of financing but prefers another, its sources will engage in an interest rate swap. In an interest rate swap, two parties exchange interest payment obligations that are denominated in the same currency. The floating/fixed rate swap is the most prevalent of all types of swaps.

Types of interest rate swaps

Interest rate swaps can be structured in a variety of ways to satisfy the specific needs of each company:

1. A ‘fixed-to-floating swap’ converts your foreign currency borrowings from fixed to floating rates, or vice versa. To reduce interest rate risk over the loan’s life, a company should switch from a floating to a fixed-rate term at the bottom of the interest rate cycle, and vice versa at the crest.
2. A ‘coupon swap,’ sometimes known as an ‘interest-only swap,’ is an agreement between two parties to swap interest rate commitments in different currencies. For example, if interest rates on the US dollar are predicted to rise, a corporation with dollar borrowings may choose to shift its interest payments to a currency with lower interest rates.
3. A ‘plain vanilla swap’, is another type of swap in which fixed and floating interest payments are based on a notional principal amount, and is the most common type of interest rate swap.

How does a currency swap work

Financial institutions, trading on their own or on behalf of a non-financial firm, are the most common participants in currency swaps. According to the Bank for International Settlements, currency swaps and forwards currently account for the majority of daily transactions in global currency markets.

FX Swaps and exchange rates

Swaps can extend for years, depending on the terms of the agreement, so the exchange rate between the two currencies in question on the spot market can fluctuate considerably throughout the duration of the trade. Currency swaps are used by organisations for a variety of reasons. They know exactly how much money they will get and how much they will have to repay in the future. If they need to borrow money in a specific currency and expect that currency to appreciate significantly in the coming years, a swap can assist them to reduce the cost of repaying that loan.

FX Swaps and cross-currency swaps

A currency swap is also known as a cross-currency exchange, and the two are nearly identical in terms of functionality. However, there may be minor variations. A cross-currency swap is similar to an FX swap in that the two parties exchange interest payments on the loans throughout the swap’s duration, as well as principal amounts at the beginning and the end. Interest payments are sometimes included in FX swaps, although not always. Interest can be paid in a variety of ways. A fixed or floating rate can be paid by both parties, or one party can pay a floating rate while the other pays a fixed rate. This form of swap generally helps borrowers achieve cheaper interest rates than they could get if they were required to borrow directly in a foreign market, in addition to managing exchange-rate risk.

Illustration to show the functioning of currency swap

Consider a corporation that has US dollars but requires British pounds to start a new business in the UK. Meanwhile, a British corporation requires US funds to make a US investment. They find each other through their banks and come to an agreement where they both acquire the money they need without having to go to a foreign bank for a loan, which would almost certainly come with higher interest rates and a larger debt load. Currency swaps are not required to be recorded on a company’s balance sheet, although loans are.

Benefits of currency swaps

1. Currently, swaps allow businesses to make use of their comparative advantage in raising funds in one currency in exchange for savings in another.
2. Currency swaps allow businesses to switch their loans from one currency to another based on their predictions for future currency and interest rate movements.
3. It gives companies more options when it comes to hedging the risk of a certain currency.
4. If a corporation has chosen the wrong currency for its overseas finance operations, currency exchange can rectify the damage.
5. Currency swaps allow you to lock in exchange rates for a longer length of time without having to monitor and review them.
6. To restructure the currency base of a company’s liabilities, the currency swap mode can be selected.
7. Currency swaps are used to reduce the cost of raising funds and to mitigate currency risk on future receipts (asset swaps) and payments (liability swaps).
8. The currency swap market’s strong liquidity provides a continual supply of principals willing to take the other side of a transaction.
9. In a currency swap, the maturity exchange rates are known from the start.
10. By mutual agreement, the counterparties may be able to terminate swap arrangements early.
11. Currency swaps can be entered into at any point during the transaction’s life cycle, and they are used to hedge.

Disadvantages of currency swaps

1. In the short run, the costs of putting up a currency swap may make it unattractive as a hedging tool against currency swings. In the long run, where the risk is higher, the swap may be more cost-efficient than other types of derivatives. One downside is that there is always the possibility that the other party to the contract will default on the agreement.
2. There is a risk of Central Government interference in exchange markets. The same thing happens when a government purchases a large quantity of foreign debt in order to temporarily stabilise their country’s weakening currency, which can result in a significant drop in the local currency’s value.

The market for swaps to function

Swaps account for 80% of the worldwide derivatives market, with a market capitalisation of $320 trillion as of 2015. The swap market has long been considered an ‘Over the Counter Market’ since these products are often tailored to the needs of the client and are difficult to standardise so that they can be sold in an exchange. The swap market, on the other hand, is one of the world’s largest, most liquid, and competitive markets. Despite these qualities, it has not been immune to digitisation in recent years, and a considerable number of the most popular contracts are now negotiated electronically using platforms such as Bloomberg, Tradeweb, or individual brokers’ platforms. The swap market is undergoing significant regulatory changes in order to improve openness and access to information while also lowering systemic risk.

What is a currency swap agreement 

A currency swap is an agreement to swap fixed or floating rate payments in one currency for fixed or floating rate payments in another currency, as well as an exchange of principal currency amounts. A consumer can re-denominate a loan from one currency to another by using a currency exchange. The aim is to match the difference between a currency’s spot and future rates over a set period of time. The re-denomination of a currency is done to reduce the cost of debt borrowing and to protect against exchange risk. 

In most swap transactions, institutions with a global presence operate as mediators, bringing the two parties together. Banks may become counter-parties to a swap arrangement and attempt to mitigate the risk they are taking by entering into an offsetting swap deal. Banks might also take positions in the futures markets to protect themselves.

In currency exchange, a common approach is to include simply the loan principal in the agreement. The parties agree to swap the principal of their loans at a certain rate at a set point in the future. Alternatively, the principal exchange of the loans could be combined with an interest rate swap, in which the parties swap the interest streams on the loans. The currency exchange in some situations would only apply to the interest on the loans, not the principal. Over the course of the arrangement, the two interest streams would be switched. As these interest streams are in separate currencies, the payments would be made in full by each party rather than being netted into a single payment as would be the case if only one currency was involved. 

Currency swaps provide the advantage of bringing together two parties who each have a competitive edge in a specific market. A domestic corporation, for example, may be able to borrow on better terms than a foreign company in a given country. As a result, a currency swap would make sense for a foreign corporation entering that market. The cost of obtaining a willing counterparty is one of the costs that a firm seeking a foreign currency swap may face. This could be accomplished through the use of an intermediary or through direct negotiations with the opposing party. In terms of fees imposed by an intermediary or the cost of management time spent negotiating, the process could be costly. There will also be legal fees associated with drafting the currency swap agreement.

Top clauses that must be present in a currency swap agreement

A general overview of the clauses that are a must in a currency swap agreement have been provided hereunder:

1. Provisions on termination of the agreement: This segment will be consisting of provisions on the following:

• Payment of early termination.
• Termination currency.
• Additional termination event.

2. Tax representations:

• Payer tax representations.
• Payee tax representations.

3. Agreement to deliver documents: 

• Tax forms, documents or certificates to be delivered.
• Other documents to be delivered.

4. Miscellaneous: 

• Addresses for notices.
• Process agent.
• Offices.
• Multibranch party.
• Calculation agent.
• Credit support document.
• Credit support provider.
• Governing law.
• Netting of payments.

5. Other provisions:

• Payments.
• Payment instruction for both parties of the transaction.
• Representations.
• Event of default.
• Termination. 
• No set-off.
• Transfer.
• Facsimile transmission.
• Definitions.
• Interpretations.
• International Swaps and Derivatives Association (ISDA) Definitions.
• Inconsistency.
• Limitation on liability.
• Procedures for entering into transactions.
• Replacement currency swap agreement.
• Disclosure to related bodies corporate.
• Appointment of manager.
• Anti-money laundering.

Key takeaways of a currency swap agreement 

1. The equivalent principal amounts are exchanged at the spot rate, at the beginning of the swap.
2. Each side pays interest on the exchanged principal loan amount for the duration of the swap.
3. The principal amounts are exchanged back at the end of the swap at either the current spot rate or a pre-agreed rate, such as the rate of the original principal exchange. Use of the original rate would eliminate the swap’s transaction risk.

Take, for example, an American corporation may be able to borrow at a rate of 6% in the United States, but a loan in rand is required for an investment in South Africa, where the equivalent borrowing rate is 9%. At the same time, a South African company wants to fund a project in the US, where the direct borrowing rate is 11%, compared to 9% in South Africa. A fixed-for-fixed currency exchange allows one party to gain from the interest rate of the other. In this scenario, the American firm can borrow dollars at 6% interest and then lend the money to the South African firm at 6% interest. The South African firm can borrow South African rand at 9% and then lend the money to the US firm for the same amount.

Terminologies that need to be acknowledged while dealing with a currency swap agreement

1. Balance of payment (BOP)

1. A country’s balance of payments (BOP) can be defined as a systematic account of all of the country’s economic dealings with the rest of the world during a given time period, usually a year.
2. The BOP account can have a surplus or a deficit overall.

• If there is a deficit, money can be taken from the Foreign Exchange (Forex) Account to cover it.
• The term ‘BOP crisis’ refers to a situation in which the reserves in a currency account are running out.

3. The components of BOP includes the following: 

• Current account: It depicts the export and import of visible and invisibles, respectively (includes goods and services).
• Capital account: It depicts a country’s capital spending and revenue. It summarises both private and public investment flows into a given economy.
• Errors and omissions: The payment balance does not always balance. Errors and omissions in the BoP reflect this imbalance.

2. Foreign exchange reserves

1. A central bank’s foreign exchange reserves are assets denominated in a foreign currency.
2. Foreign currencies, bonds, treasury bills, and other government instruments are examples of foreign exchange reserves.
3. These reserves are utilised to back liabilities and exert monetary policy impact.

Things to remember about currency swap agreements

1. Swap is a term that signifies ‘exchange.’ A currency swap is an agreement or contract between two countries to exchange currencies under predetermined terms and circumstances.
2. A currency swap, (for example) is effectively a loan from Bangladesh to Sri Lanka in dollars, with the promise that the debt will be returned in Sri Lankan rupees with interest. This is a better deal for Sri Lanka than borrowing from the market and is a lifeline as the country struggles to retain appropriate foreign exchange reserves (FX reserves) as it prepares to repay its external obligations.
3. Currency swaps are used by central banks and governments to address short-term foreign exchange liquidity needs or to assure adequate foreign currency to avert a Balance of Payments (BOP) crisis until longer-term arrangements can be established.
4. As the transaction terms are determined in advance, there is no exchange rate or other market risks in these swap operations. Exchange rate risk, often known as currency risk, is the financial risk posed by changes in the value of a base currency relative to a foreign currency in which a firm or individual has assets or liabilities.

How can India benefit from currency swap agreements

1. So far, the Government of India’s Ministry of Commerce has finalised agreements with 23 nations with which Indians can trade in local currencies. Simply put, both countries’ importers and exporters must quote and receive settlements in their own currencies. For starters, there is no third-country currency involved, so there is no need to be concerned about exchange rate fluctuations. 
2. India has placed a strong emphasis on persuading nations with large or significant trade deficits with India to join this agreement. Dues are still payable in rupees, avoiding the need to settle in foreign exchange in US dollars, Euros, or other currencies. Once the Ministry of Finance has approved the countries with which such an arrangement would be mutually beneficial, the Ministry of Commerce is in charge of initiating bilateral talks to reach an agreement.
3. It should be remembered that in the instance of Iran, 45 percent of the dues for oil imports were paid in Rupees and credited to their UCO Bank account in Kolkata. In Turkey, the balance was made available in Euros. Iran now has a credit balance of Rs 50,000 crore (about $6 billion), and it is in our best interests to work closely with them to suit their needs in terms of products, services, and turn-key projects.
4. It should be mentioned that in the first half of the fiscal year 2013-14, the government’s foreign exchange reserves were depleted by $10.7 billion due to a drop in net capital inflows.
5. Fortunately, key oil exporters such as Angola, Algeria, Nigeria, Iran, Iraq, Oman, Qatar, Venezuela, Saudi Arabia, and Yemen are included in this list of CSA countries. Currently, we are working to expand our exports to Iran, Iraq, Oman, Qatar, and Saudi Arabia. We have advanced countries like Japan, Russia, Australia, and South Korea on the list of non-oil exporters with which we have major commerce, as well as Singapore, Indonesia, Malaysia, Mexico, South Africa, and Thailand. Japan has boosted the volume from $15 billion to $50 billion to allow trade between the two friendly nations to flourish without the use of third currencies. Our current account deficit has shrunk to around 2% of GDP, down from 4.5 percent in the first half of last year. Exporters must take advantage of the current arrangements and support the government’s efforts by closely sticking to the rupee trade quotations.
6. In terms of promotion, India should make an effort to attend international trade exhibits in all of these nations and fund trade delegations in order to expand our commerce. The Ministry of Commerce must take the lead in launching vigorous promotional activities in the nations named above, particularly Iran, Nigeria, Qatar, Saudi Arabia, Japan, South Korea, Mexico, and Venezuela, with whom we have debit balances. Incredible India advertisements on local television and through local chambers of commerce might be beneficial. Efforts to promote India as a viable and serious trading partner would assist to solidify our ties with these nations.

The SAARC currency swap framework

The SAARC currency swap mechanism went live on November 15, 2012, with the goal of providing a backstop line of finance for short-term foreign exchange liquidity needs or short-term balance of payments stress until longer-term arrangements can be negotiated. In November, the RBI decided to implement a revised framework (2019-2022) on currency exchange arrangements for South Asian Association for Regional Cooperation (SAARC) countries, with the approval of the Indian government, with the goal of promoting financial stability and economic cooperation within the SAARC nations. From November 14, 2019, till November 13, 2022, the framework will be in effect. The RBI will enter into bilateral swap agreements with SAARC central banks that desire to use the swap facility based on the framework’s terms and criteria.

Within the entire corpus of USD 2 billion, RBI will continue to offer swap arrangements under the framework for 2019-22. Withdrawals are available in US Dollars, Euros, and Indian Rupees. Certain advantages are available for swap drawals in Indian Rupee under the Framework. All SAARC member countries are eligible for the facility if they execute bilateral swap arrangements. Afghanistan, Bangladesh, Bhutan, Maldives, Nepal, Pakistan, and Sri Lanka are the other members of the SAARC.

What is this currency swap arrangement (CSA)

An agreement between two friendly countries to trade in their respective national currencies. Both countries pay for import and export commerce at predetermined exchange rates, rather than bringing in a third-country currency such as the US Dollar, as per the agreement. There is no third-country currency involved in such arrangements, therefore concerns about exchange rate fluctuations are the least requirement. The Reserve Bank of India has agreed to a $400 million currency swap facility for Sri Lanka till November 2022.

Significance of the currency swap arrangement

1. Improves the Indian market’s confidence.
2. Allows India to access the agreed-upon amount of funds.
3. Reduce the cost of finance for Indian companies seeking to enter the international capital market.
4. Aids in the stabilisation of India’s foreign exchange and capital markets

Notable currency swap agreements 

Two notable currency swap agreements and associated information relating to them have been shared hereunder. 

Indo-Japan currency swap arrangement

The Union Government of India had signed a bilateral currency swap arrangement with Japan in 2018. The country that takes out the loan pays interest to the country that gives it to them at a benchmark interest rate, such as LIBOR. While India has such agreements with a number of Asian countries, the one with Japan is the largest, valued at $75 billion. The administration expects that this agreement will serve as a buffer for the rupee, which has lost 14% of its value against the dollar in 2018

How did the Indo-Japan currency swap agreement work

1. The currency swap agreement allowed the Reserve Bank of India to borrow up to $75 billion in yen or dollars from the Japanese government anytime it needed.
2. The RBI could sell these dollars (or yen) to importers to settle bills or to borrowers to repay foreign borrowing.
3. The Reserve Bank of India could even keep the money to shore up its own foreign exchange reserves and protect the rupee.
4. While the RBI had $426 billion in foreign currency reserves by April 2018, it has had to use part of it in recent weeks to keep the rupee afloat.
5. Though the RBI’s current FX reserves of over $390 billion are sufficient, having a $75 billion loan-on-demand from Japan provides an additional buffer.

The reason behind the Indo-Japan currency swap arrangement 

1. The rupee has been losing ground versus the dollar in recent months due to the country’s expanding current account deficit (the difference between imports and exports of goods and services).
2. As a result, importers’ demand for dollars rises well above what exporters bring into the country.
3. A swap agreement with Japan provides substantial confidence to India, as Japan is the world’s second-largest holder of dollar reserves, after China, with over $1.250 billion in cash on hand.
4. As a result, while Japan is unlikely to request a dollar loan from India, India can benefit from such a loan at extremely low-interest rates.
5. This agreement could also be seen as a payoff for lucrative investment deals that assist Japanese corporations in setting up companies in India.

What does the Bangladesh-Sri Lanka currency swap mean

Bangladesh’s Central Bank has approved a $200 billion currency swap facility to Sri Lanka. According to Bangladeshi media sources citing the bank’s spokesman, the Bangladesh Bank has authorised in principle a $200 million currency swap agreement with Sri Lanka, which will aid Colombo in overcoming its foreign exchange problem. Sri Lanka is in desperate need of foreign money, with an external debt repayment schedule of $4.05 million that was due in 2021. Its own foreign exchange holdings were $4 million as of March 2021. To put the facility sanctioned by Bangladesh Bank into action, the two parties must sign a written agreement. Following a proposal from Sri Lankan Prime Minister, Mahinda Rajapaksa to Bangladesh’s Prime Minister Sheikh Hasina. In this, Dhaka consented to extend the service.

What does currency swap mean in this context 

A currency swap, in this context, is effectively a loan from Bangladesh to Sri Lanka in dollars, with the promise that the debt will be returned in Sri Lankan rupees with interest. This is a lifeline for Sri Lanka, which is struggling to retain adequate forex reserves as payback of its external obligations approaches. The agreement will specify the duration of the currency swap.

Is it unusual for Bangladesh to swap currency with Sri Lanka

1. Bangladesh has not been perceived as a source of financial aid to other countries in the past. It has long been one of the world’s poorest countries, and it continues to receive billions of dollars in aid. However, over the last two decades, it has literally dragged itself up by the bootstraps, and by 2020, it will be the fastest-growing economy in South Asia.
2. Bangladesh’s GDP expanded by 5.2% in 2020 and was anticipated to expand by 6.8% in 2021. Millions of people have been lifted out of poverty throughout the country. Its per capita income recently passed that of India. This may be the first time Bangladesh has offered assistance to another country, thus it is a watershed moment.
3. Bangladesh’s foreign exchange reserves were $45 billion in May 2021. Despite predictions that the pandemic would have a negative impact on remittances, Bangladeshis residing abroad sent over $21 billion in 2020. Sri Lanka is also borrowing from a SAARC country other than India for the first time.

Why didn’t Sri Lanka approach India, the biggest economy in the region

Sri Lanka did approach India for a currency swap, but it received no response from the nation. President Gotabaya Rajapaksa met with Prime Minister Narendra Modi in 2020 to request a $1 billion credit swap and, separately, a freeze on debt repayments to India. However, tensions have arisen between India and Sri Lanka as a result of Colombo’s decision to reject a vital container terminal project at Colombo Port. 

India delayed making a choice, but Colombo no longer has that luxury. Sri Lanka had already lost one of its main foreign exchange pullers before the pandemic, with the tourism industry decimated since the 2019 Easter bombings. The pandemic, which is harming exports, has also hit the tea and clothing industries. In 2020, remittances grew, but they were not enough to help Sri Lanka out of its dilemma.

China already owes the country a large amount of money. Sri Lanka received a $1.5 billion currency swap facility from Beijing in April 2021. Separately, China, which provided Sri Lanka with a $1 billion credit in 2020, has extended the second $500 million tranches of that loan. Sri Lanka, according to media estimates, owes China up to $5 billion.

Sri Lanka’s tourism industry may suffer greatly as a result of the prolonged FX crisis. The economic situation in Sri Lanka is deteriorating, according to the latest British government report, with shortages of basic needs such as medications, petrol, and food due to a lack of foreign currency to pay for imports. Grocery stores, gas stations, and pharmacies may have long lines. Local governments may implement electricity rationing, resulting in power disruptions, according to the alert. Canada has also recommended its citizens to keep food, water, and fuel on hand in case of prolonged interruptions, as well as to ensure that they have an adequate quantity of medicines on hand in case they are unavailable, and to keep an eye on local media for the latest developments. 

Credit swap facility that India gave Sri Lanka in 2020

The Reserve Bank of India (RBI) did grant a $400 million credit swap facility to Sri Lanka in July 2020, which was settled in February 2021 by the Central Bank of Sri Lanka. The contract was not renewed. The RBI has a structure in place that allows it to grant credit swap facilities to SAARC countries up to a total of $2 billion. The SAARC currency swap facility was launched in November 2012 with the goal of providing “a standby line of finance for short-term foreign exchange liquidity requirements or balance of payment crises until longer-term arrangements are made,” according to RBI.

This information was already communicated by the Indian High Commission in Colombo to senior authorities in the Sri Lankan government and the Central Bank of Sri Lanka. According to a High Commission statement, on July 22, the High Commission supported fruitful technical discussions on Sri Lanka’s bilateral debt repayment rescheduling. According to the statement, “these positive developments demonstrate active implementation of the leadership-level commitment to work together to address the challenges arising from the COVID-19 pandemic and further the mutually beneficial India-Sri Lanka partnership, including in the economic domain.”

How do companies benefit from interest rate and currency swaps

Companies can use currency and interest rate swaps to traverse the global markets more efficiently. Swaps of currency and interest rates bring two parties together who have a competitive edge in distinct markets. Interest rates and currency swaps, in general, provide the same benefits to a corporation. 

The interest paid on the principal amount and the currency utilised for payment differ in the interest rate and currency swaps. An interest rate swap is a transaction in which two parties exchange cash flows based on interest payments for a specific principal amount. A currency swap entails exchanging the principal as well as the interest rate in one currency for the same amount in another. A currency swap is an ‘off-balance-sheet’ transaction because it is a foreign exchange transaction. 

A cross-currency exchange can also be beneficial for a corporation that has issued bonds in a foreign currency and wants to convert those payments into local currency. Currency swaps are sometimes necessary when a corporation receives a loan or revenue in a foreign currency that needs to be converted to local currency, or vice versa.

Currency and interest swaps in case of companies 

The interest paid on the principal amount and the currency utilised for payment differ in the interest rate and currency swaps. These derivatives or securities allow corporations to minimise or control their exposure to interest rate volatility or achieve a lower interest rate than they would otherwise be able to receive. Swaps are frequently employed since a domestic company can typically get better rates than a foreign company. As a currency swap is a foreign exchange transaction, it is not legally required to be reported on a company’s balance sheet. This means that they are ‘off-balance-sheet’ transactions, and a company’s swap debt may not be declared in its financial statements.

Assume that firm A is based in the United States and company B is based in the United Kingdom. Company A must take out a loan in British pounds, while Company B must take out a loan in US dollars. These two companies may do a swap to benefit from the fact that each has superior rates in their respective countries. By merging their privileged access to their respective marketplaces, these two corporations may save money on interest rates. 

Swaps also assist businesses in hedging interest rate risk by minimising the unpredictability of future cash flows. Companies can use swapping to adjust their debt terms to take advantage of current or anticipated future market conditions. As a result of these benefits, currency and interest rate swaps are employed as financial tools to reduce the amount needed to pay a debt. Although there is some risk connected with the likelihood that the other party will fail to meet its obligations, the benefits of participating in a swap significantly exceed the costs.

Conclusion 

A currency swap is an agreement between two parties to exchange currencies under predetermined terms and circumstances. Currency swaps are primarily used to mitigate various risks and instability in exchange rates and foreign exchange markets. Governments and central banks conduct currency swaps with their foreign counterparts to ensure that sufficient foreign currency is available in the event of a foreign currency shortage.

References 

• https://www.moneylife.in/article/currency-swap-arrangements-how-india-can-benefit-from-it/35796.html
• https://www.researchgate.net/publication/241044989_Currency_Swaps
• https://www.businessmanagementideas.com/foreign-exchange-2/currency-swap-meaning-and-benefits-foreign-exchange-financial-management/14603

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