India?s aid to Sri Lanka

India’s aid to Sri Lanka

News: India has confirmed a $400 million currency swap with Sri Lanka while deferring another $500 million due for settlement to the Asian Clearing Union (ACU).

Background:
• Sri Lanka is facing a severe dollar crunch that economists say might lead to a default on external debt and create a food shortage in the imports-reliant island nation.
• In this regard, the Reserve Bank of India has extended currency swap facilities of $900 million to Sri Lanka.

What are Currency Swaps?
• A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies.Currency swaps are used to obtain foreign currency loans at a better interest rate than could be got by borrowing directly in a foreign market.
• In a swap arrangement, RBI would provide dollars to a Lankan central bank, which, at the same time, provides the equivalent funds in its currency to the RBI, based on the market exchange rate at the time of the transaction.
• The parties agree to swap back these quantities of their two currencies at a specified date in the future, which could be the next day or even three months later, using the same exchange rate as in the first transaction.
• These swap operations carry no exchange rate or other market risks, as transaction terms are set in advance.

Need for currency swaps:
• FPIs investors look for safer investments but the current global uncertainty over COVID outbreak has led to a shortfall everywhere in the global markets.This has pulled down foreign exchange reserves of many small and developing countries.This means that the government and the RBI cannot lower their guard on the management of the economy and the external account.

Benefits:
• The absence of an exchange rate risk is the major benefit of such a facility.This facility provides the flexibility to use these reserves at any time in order to maintain an appropriate level of balance of payments or short-term liquidity.
• Swaps agreements between governments also have supplementary objectives like the promotion of bilateral trade, maintaining the value of foreign exchange reserves with the central bank and ensuring financial stability (protecting the health of the banking system).