By Sudipta Purkayastha, Gujarat National Law University.

The Indian Prime Minister Narendra Modi has, since practically the beginning of time, stressed on the importance of maintaining friendly relations with other states, especially those in South Asia.

This March, he lived upto his motto once again, by visiting Sri Lanka for talks aiming at improving bilateral ties between the two nations. The first Indian Prime Minister to visit Sri Lanka on a bilateral basis since 1987, Mr. Modi made a practical gesture of his belief that economic ties are “a key pillar of relationship between the two countries”. Further, the Indian premier has stated that the progress in the relations between the two nations “reflects [a] shared commitment to stronger economic cooperation”.

Back in 2012, the SAARCFINANCE Governors’ meeting held in Nepal had witnessed the Reserve Bank of India announcing that it plans to offer currency swap arrangements aggregating $2 billion, both in foreign currency and Rupee to all South Asian Association for Regional Cooperation (SAARC) member countries, which includes Afghanistan, Bangladesh, Bhutan, Maldives, Nepal, Pakistan and Sri Lanka. This facility can be availed by any of these nations till November 14, 2015, with a floor of US $100 million and the ceiling being US $400 million within an overall limit of US $2 billion.

What, one may firstly ask, is a “Currency Swap”?

A currency swap entails two parties exchanging “one currency for another on one value date and thereafter reversing the transaction on another value date”. This may be carried out in order to enable the conversion of principal and interest payments of a loan, i.e., liabilities in one currency for an equivalent liability in another currency. It may exchange an investment (asset) in one currency to an investment in another currency, as well.

Owing to such an arrangement, each party has the use of the other’s currency. This provides the parties an access to adequate foreign currency required to make purchases in foreign markets. Thus, parties are able to gain entrance into new capital markets or to provide predictable revenue streams in another currency. Once the contract ends, the parties re-exchange the principal amount of the swap.

They are considered foreign exchange transactions that serve two main purposes:

  1. They may lead to minimization of foreign borrowing costs.
  2. They may aid to hedge exposure to exchange rate risk.

Currency swap maturities are negotiable for a minimum of 10 years, resulting in these agreements being exceedingly flexible.

There are four ways of basic currency swaps: fixed for fixed, fixed for floating, floating for fixed and floating for floating.

The SAARC Currency Swap Framework is meant for providing backstop line to the SAARC member countries in particular, in order to overcome balance of payments and liquidity crises. During such crisis, a fund will be provided till more permanent arrangements may be possible, or till short-term liquidity is required owing to stressed market conditions.

Keeping this SAARC framework in mind, thereafter in 2013, the government issued statements stressing on the need for bringing about such currency swap agreements with trade partners with the purpose of expanding on exports and reducing trade deficit, which has put the rupee under tremendous pressure. As per the Ministry of Commerce, it was felt important to “examine the issue of currency swap agreement and its impact on the Indian trade policy”.

Accordingly, the Ministry had then sought the advice of the Centre for WTO Studies, which, in its concept paper submitted to the Ministry, had opined that such agreements “help in fund management and currency risk management”, among other benefits. Further, it was felt that there might be both positive and negatives of bringing forth these agreements with countries wherein India has trade deficits.

Ideally, it said, such dollar swap arrangements would generally aid India in strengthening the Rupee, which had been seeing alarming depreciation against the US currency. Following the 2008 Global Financial Crisis, such swaps have been fundamental in managing to hedge exchange rate risks, as well as providing confidence to, and preventing additional volatility in financial and foreign exchange markets, as per the report of the Ministry.

That same year, India went on to sign currency swap agreements with Japan ($15 billion) and Bhutan ($100 million), in keeping with the observations of the Ministry of Commerce.

Come 2015, India is ready to move down this path with Sri Lanka –  for Prime Minister Modi’s visit to Colombo entailed, him announcing a currency swap agreement with Sri Lanka. On the 17th of July, the Reserve Bank of India (RBI) signed a special agreement with the Central Bank of Sri Lanka, allowing the latter to draw up to $1.1 billion for a maximum period of six months, in withdrawals of US Dollar or Euro in multiple tranches, for a maximum of $400 million or its equivalent.

Sometime earlier in March of this year, RBI had signed a similar Currency Swap Agreement with the Sri Lankan bank for $400 million, however that was under the SAARC Framework, and thus within the overall limit of 2 billion dollars.

This time, however, the agreement is to be valid for only 6 months as an ad-hoc swap facility outside the Framework, but with the same terms and conditions as under the SAARC Framework, as per the request made by the Central Bank of Sri Lanka. This was determined by the Indian Government in April 2015, based on the recommendation of the RBI, in order to  mitigate the possible currency volatility in the region, and also to strengthen India’s bilateral relations and economic ties with Sri Lanka, as per the press release of the RBI.

With the Sri Lankan Rupee seeing whirlwind falls and tremendous pressure lately despite several attempts made by the Central Bank, this currency swap pact assumes considerable significance for the island nation. At the time of writing this article, one Indian Rupee was equivalent to 2.09 Sri Lankan Rupees, indicating that the Sri Lankan currency has dropped almost three per cent in value, in comparison to the Indian Rupee so far in 2015.

With this agreement in place, Sri Lanka will now be capable of casting a safety net against the probable volatility of their currency, and there will be atleast short-term liquidity that one hopes shall hasten Sri Lanka’s economic recovery.

India’s strive to consolidate its relations with its southern neighbour is indeed an exceedingly positive move, and one can only hope that this shall further bring about financial stability in the region.