As part of this, the Indian and the Japanese governments on Friday agreed to enhance the bilateral swap agreement (BSA) from $15 billion to $50 billion.
Japan, which has foreign exchange reserves of over $1.25 trillion, has signed similar currency swap pacts with the Philippines, Indonesia and South Korea.
Under this swap arrangement, both the countries can swap their respective domestic currencies for dollars to meet short-term liquidity mismatches.
“For any economy, drawing down of its FX reserves is usually the first line of defence against external funding problems. BSAs tend to usually be more of a second line of defence as access to such a facility is often seen as a precursor to approaching the IMF,” said Nomura Securities in a note, adding that the agreement should enhance the country's ability to address the market stress.
Finance ministry sources told FE that according to the agreement, the country borrowing dollars will pay interest at Libor + 150 basis points. The borrowing tenure is of three months (90 days), and as per the pact, seven extensions are allowed. The borrowing country will also have to pay a stipulated penalty in case of a default.
“The pact is a safety net. It will be used only if the forex reserves fall below the comfort level,” a finance ministry official said. The central banks of the two countries will take a call on when to use the pact.
In 2008, Indian and Japan had first signed a $3-billion currency swap agreement, but this limit was unused. Against the backdrop of the euro zone crisis in December 2012 and a similar fall in the rupee value against the dollar, both the countries enhanced this limit to $15 billion.
The announcement added to the turn in sentiment on the rupee which rebounded significantly from an intra-day low of 66.30/$ to close at 65.25/$ on Friday, up 1.3% from Thursday's close of 66.11/$. It closed at a two-week high.
The rupee has now rebounded 5.9% from its all-time low of 68.85 in response to a host of measures aimed at drawing in dollars announced by RBI governor Raghuram Rajan who took charge on Wednesday.
Among these was a decision to allow banks to raise foreign currency non-resident (FCNR) deposits and swap them at a fixed cost of 3.5% with the RBI — a measure that could draw in up to $10 billion.
Banks were also allowed to raise 100% of Tier-1 capital through overseas borrowings and swap those at a 100 basis point discount with the RBI.
“The swaps are positive in the short-term to attract capital. I think one needs to see the operational details that would come out, and that would define how much capital would come in. The move to take out the oil demand from the market has been the big positive,” said Brijen Puri, head of trading at JP Morgan.
The measures to bring in dollars and establish emergency swap lines will help ease fears about India's dwindling forex assets, which fell by another $3 billion during the week ended August 30, 2013. According to RBI data, foreign currency assets fell to $247 billion and overall foreign currency reserves fell to $275 billion at the end of August.
Forex reserves have fallen a massive $16 billion since April and are barely adequate to cover seven months of imports.
The RBI's special swap window for oil companies, which virtually removed a daily demand of $300-$400 million from oil companies from the forex market, may have a further short-term impact on reserves. However, since the oil companies will sell back the dollars to the RBI at a later date, reserve levels will eventually not be impacted.
Further, some economists said that the swap offered to banks' on FCNR(B) deposits would replenish the dollar reserves.
“This buy-dollar, sell-rupees swap move may be seen against the current sell-dollar, buy-rupee swap measures initiated by the RBI for oil marketing companies,” said a research note from State Bank of India.
The swap facility for oil companies announced on August 28 boosted the currency by 3.3% in a single day from its all-time low.