India is expected to enter into a multi billion dollar currency swap arrangement with Japan to raise dollar funds to increase the central bank's firepower to fight the uncertainty that has gripped the currency markets since August. ET looks at the concept of currency swaps and how this arrangement could help India's currency markets.

What Is A Currency Swap Arrangement?

A simple currency swap is a transaction that involves the exchange of principal and/or interest in one currency for the same in another currency. The purpose of currency swap is to hedge against risk associated with exchange rate movements, ensure receipt of foreign currency, and to achieve better lending rates. There are a number of combinations under which companies can pay or receive floating/fixed rates of interest. This arrangement is generally done between companies.

How Could The Deal Be Structured Between India And Japan?

The agreement could effectively be structured in a manner where Japan will accept rupees and give dollars to India up to a stipulated limit, and similarly India will take yen and send dollars to Japan if they demand for it.

How Do Swap Agreements Help Partner Countries?

The idea of such an exchange is to allow a country to manage its short term foreign exchange liquidity problems. The country that has dollar surplus can provide the use of its reserves to another country facing short term exchange issues though a swap arrangement. Japan at present has $1.3 trillion worth of reserves while India has approximately $ 300 billion.

How Will The Swap Help To Calm Indian Markets?

The Indian rupee has faced selling pressure because of the Eurozone uncertainty. The Indian currency has depreciated almost 20% against the dollar since August. Dollar inflows have almost dried up in the subsequent months while the high inflation coupled with a burgeoning current account deficit has worsened the situation. In this situation a currency swap arrangement gives confidence to market participants that India would be able to meet its short term dollar obligations through borrowing if needed. The government could also stave off sudden speculative attacks on the currency.