A currency swap is an arrangement whereby two currencies are exchanged generally between two central banks in lies of a forward premium.
For instance, $ is exchanged for Rs. With a precondition to returning it after say, 3 years at a determined forward premium.
Pros:
- Regulating liquidity
- Helps in controlled appreciation of supplies, thereby helping exporters.
- Lower hedge cost for importers as the forward rate would be controlled.
- Due to fewer open market operations, the rise in bond yield rates.
- Lower interest rate, giving the required importers to the economy.
Cons:
- Depreciating rupee, securing as backlash for importers.
- Increased/Exclusive liquidity (more than required) could lead to inflation.
Currency swap and India:
RBI has resorted to currency swap as an alternative to conventional tools of open market operations and has received an overwhelming response over the stipulated $ 5 bn. It was a required respite to banks facing liquidity clunch in the light of IT and FS crisis, increased withdrawals due to elections and payment of taxes, being close of the financial year considering the banks as not have adequate collaterals to pudge with RBI because of high SLR & LCR, currency swap is a welfare instrument. But 5km is just 0.3% of total demand and time deposits of the banks, which is too marginal a figure.
But it will surely bring some respite to the banks and economy until the new government is elected and accelerate spending in the economy.