What is a Currency Swap and What are the Benefits?

In recent years, some countries were interested in currency swaps. In the past few months, Sri Lanka also received Currency swaps from Bangladesh and China. What does a currency swap mean? Why is it beneficial?

In this post, I’m going to briefly discuss currency swaps and their benefits. So let’s dig in. 

What is a Currency Swap?

What is a currency swap exactly? I researched this topic and here is a simple guide about currency swap.

A currency swap means a transaction between two parties. In simple terms, a currency swap means exchanging an equivalent amount of money in different currencies and paying back over a specified period.

Here’s an example. 

Imagine a  USA company wanting to initiate a project in India. And at the same time, an Indian company wants to start a project in the USA. USA company wants Indian rupees for that project and the Indian company wants US dollars for its project. 

If these two companies borrow each amount of money directly as a loan, the interest rate will be high. This means, the USA company borrows Indian rupees directly at a rate of 9% but it can borrow US dollars domestically at a rate of 6%. On the other hand, the Indian company can borrow US dollars directly at a rate of 11%, but it can take Indian rupees domestically at 7%. 

As a solution, the USA company borrows US dollars from a domestic firm at a rate of 6% and lends it to the Indian company. Also, the Indian company borrows Indian rupees at a rate of 7% and lends it to the USA company. Both companies agree to pay back at a specific time.  

Benefits

Why do many countries like to follow the currency swap method? What are the advantages of currency swap? Here are the answers.

Some developing countries follow this method to boost up their economies. Especially in this pandemic period, many developing countries are suffering from economic disabilities and a lack of foreign currency reserves. As a result, some countries seek currency swap facilities to strengthen their economy rather than taking loans directly.  For example, Sri Lanka received a currency swap facility from Bangladesh, totaling US$ 200 million.    

Currency swaps can manage the risk of uncertainty in exchange rates. We all know that the exchange rates can change due to many reasons. But during a currency swap, both parties know how exactly they should payback and it does not change with the exchange rate fluctuations.

Many parties like to use currency swaps to obtain foreign loans at a better interest rate. As for the example we discussed earlier, it is beneficial to the Indian company to borrow Indian rupees at a rate of 7% and lend it to the USA company and take US dollars for their project in the USA, rather than directly borrowing US dollars from the foreign market at a higher rate.

Conclusion

In conclusion, many economically vulnerable countries, consider currency swaps to boost up their economies. This is more beneficial to all the parties engaged with the currency swap procedure. 

However, there may be a difficulty for any party to pay back which means a risk of default.

An overall, currency swap can be identified as a good way to use instead of loans.

Image credits : Freepik.com

 

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