Angling for a swap line
FRONTLINE|May 08, 2020
Angling for a swap line
India’s central bank is in talks with the U.S. Federal Reserve for a swap line that will give it access to dollars at a time when it is experiencing large foreign capital outflows owing to the COVID-19-induced global economic crisis.
C.P. CHANDRASEKHAR

THE RESERVE BANK OF INDIA IS REPORTEDLY in discussions with the United States Federal Reserve to put in place a rupee-for-dollar swap line. If the Fed accedes, this would be a first for India but not for the Fed, which has had temporary and standing swap arrangements with chosen foreign central banks for many decades. With trade and financial transactions overwhelmingly denominated in dollars, governments, firms and households across the world are constantly in need of dollars to settle transactions. Periodically, some governments and firms, especially those not earning adequate dollars from their own exports, face dollar funding shortages. The Fed’s swap arrangements are aimed at providing central banks in partner countries access to dollars to meet demands in their jurisdictions.

Under a swap arrangement between the Fed and a foreign central bank, the latter can access dollar funding in exchange for the domestic currency of the applicant. The swap involves two transactions: the first one is the sale to the Fed of a specified volume of the applicant’s domestic currency for dollars at the prevailing market (spot) exchange rate, and the second one is a buyback on a specified date in the future of the domestic currency with dollars paid by the foreign central bank at the same exchange rate. When the second transaction is completed, the foreign central bank also pays interest at a market-related rate, which depends on the duration for which it has drawn on the swap line.

As an arrangement, a swap line allows central banks that have been provided the facility, to access dollar funding at short notice. They can use those funds directly or lend it to financial institutions in their jurisdictions in need of dollar funding and unable to access them easily from markets. The credit risk on such lending is carried by the foreign central bank, and the U.S. Federal Reserve does not enter as a party in any form in those subsequent transactions. In addition, the Federal Reserve is not faced with any foreign exchange risk on the capital provided since the sale and repurchase of the foreign currency to and from the Fed is at the same exchange rate.

The strain in dollar-funding markets tends to be severe in times of economic difficulty when the foreign exchange earnings of many countries fall and financial investors move their funds into the safe havens that both the U.S. and the dollar tend to be. Such strains have only intensified after financial globalisation, which enhanced the presence of foreign investors in financial markets in developed and emerging markets, with most transactions denominated in dollars. If investors choose to pull out, dollar availability reduces. In response to this changed situation, the Fed has tended to aggressively deploy its swap instrument in times such as the global financial crisis of 2007-08, when dollar-funding markets broke down, straining the financial system in foreign locations. It has also chosen to rely on this instrument in the current COVID-19-induced crisis that has overwhelmed both the real economy and financial markets the world over.

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May 08, 2020