CURRENCY SWAP, Currency swap between Companies, Central Banks

CURRENCY SWAP:

• Currency swap is an agreement between two cross-border entities where one of them agrees to provide a loan to another in a foreign currency. 
• These entities can be either companies, countries or the central banks 
• The repayment takes place in foreign currency/Dollar at a fixed date and a pre decided Exchange Rate
• The interest rate charged on such loans is usually lesser than that available in the foreign market.

Currency swap between Companies:

Let us take the example:

• US-based company XYZ Inc. which can borrow in the US at an interest rate of 5%, but the company requires a loan in Pound sterling for investment in the UK, where the prevailing interest rate is 8%.
•  At the same time, a UK-based company ABC is willing to invest in a US project but funds to ABC in US are available at 9% in comparison to the UK’s 6% interest rate.
• Company XYZ & Company ABC can benefit by entering into a fixed-for-fixed currency swap contract.
• US-based company XYZ Inc. ------ Borrow a US dollar loan at 5% in US ------------Lend the proceeds to the UK-based company ABC Plc. at that rate. 
• UK-based company ABC Plc. -------Borrow a Pound sterling loan at 6% -------------Lend it to the US-based company XYZ Inc.

Win -Win Situation for Co. XYZ Inc. & Co. ABC Plc.:

XYZ Inc. saved 2% (= 8% – 6%) in interest rate, while ABC Plc. saved 4% (= 9% – 5%). This is how the participating parties benefit from a currency swap.

How Bilateral Currency Swap between central banks works:

• Currency Swap was very much popular During the financial crisis -2008 as banks were reluctant to lend to one another because of the financial uncertainty.
• This resulted in the increase in the cost of borrowing, as lenders demanded higher interest rates to compensate for rising counterparty risk.
• This issue was very critical in case of Foreign Currencies as developing countries were looking for Dollars for trade.

• In the example, there is currency Swap between USA and Sri Lanka. 
• USA provide Dollars in Jan 2024 with commitment to give it back on Jan 2029 with predefined Exchange Rates and date. 

Importance and issues of FDI, FDI Policies in India since Independence

Why Countries Seek FDI: 

• FDI supplements domestic investment as Domestic capital is inadequate for purpose of economic growth.
• FDI is non debt capital and brings capital, technical know how and increases competitiveness of the economy .
• ⇓FDI Improves forex position of the country alongwith helping in capital formation by bringing fresh capital . 
• The association of FDI players in global marketing network play a major role in the promotion of exports .

Issues with FDI :  

• Role of FDI depends whether it crowds out or crowds in the domestic investments.
• In case of crowding out, Small Domestic enterprises find it difficult to compete with companies bringing FDI and feels that they may ultimately be edged out of business. 
• These MNC's have deep pockets and have ability to monopolise and take over the highly profitable sectors;
• These MNC's invest more in machinery and intellectual property than in wages of the local people;
• Government has less control over the functioning of such companies as they are subsidiary of an overseas company.

CO RELATION BETWEEN FDI AND FOREX: 

                               The MNC will need INR to carry out day to day job or purchase.

                                ⇊

                               FDI- Foreign Currency will be converted to INR 

                                                                         Foreign Currency 

   Company                                                  ⇄                                            RBI

                                                                                INR     

                                                        ⇊

                     Forex with RBI will increase

Why India has become FDI attractive :

• Unlike China, FDI in India is not export growth oriented as India does not impose any export obligation on MNC affiliate which attracts MNC's.
• Huge market size, growth prospects in tier-2 and tier-3 cities and growth  of infra are the motivating factors for attrracting FDI.
• Rise of high-tech sectors, market size, and digital and technological improvements are also driving India’s growth trajectory, making it an attractive investment destination.
• Innovative FDI initiatives by government in industries such as asset reconstruction firms, broadcasting, pharmaceuticals, single-brand retail trading etc are also promoting FDI investments.
• The Atmanirbhar Bharat aims to increase FDI in the defence sector by 74% through an automated route.The percentage of FDI inflows into the insurance sector has been boosted by the government from 49% to 74%.
• Policies like Production-Linked Incentive (PLI) programmes, Make in India , PM Gati Shakti, Foreign Trade Policy, Liberal FDI norms, PTAs and FTAs and the National Single Window System (NSWS) are motivating investors to set up manufacturing units in India. 

FDI ENTRY IN INDIA:

Independence to 1965-67:

• Post independence ,domestic funds were limited and basic infrastructure was to be developed so there was  receptive attitude with cautious towards FDI .
• There was non discriminatory treatment to FDI until mid of 60’s. 

1965-1980's :

Till mid of 1960’s local manufacturing base was developed with the flow of FDI  but it was accompanied by a lot of outflow in the form of remittances of dividends ,profits, royalties and technical fee .

1980-1990 :

• Outflow during 1965-80's led  policy makers to make  FDI  policy to be restrictive and selective post 1980's.
• Restriction on FDI was there if it was not entering without technology .
• Stake above 40 % ownership  was not allowed and it was allowed only in priority areas.

1991 onwards :

Paradigm shift from restrictive and selective to open door policy. 

The present FDI policy :

Characterized by Negative Listing permitting FDI in all the fields except a few in negative list. 

There are 3 methods of FDI entry in India :

1.Prohibited sectors                                                          

2.FDI is allowed upto a certain limit

3.100 % FDI :

• with automatic approval 
• with the approval of the government

At present, FDI is prohibited  in :

 a) Lottery Business 

b) Gambling and Betting including casinos etc. 

c) Chit funds 

d) Nidhi company 

e) Trading in Transferable Development Rights (TDRs)

f) Real estate business which shall not include development of townships, construction of residential /commercial premises, roads or bridges and Real Estate Investment Trusts (REITs) registered and regulated under the SEBI (REITs) Regulations 2014.

g) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes

 h) Activities/sectors not open to private sector investment e.g. (I) Atomic Energy and (II) Railway operations (other than permitted activities mentioned in permitted sectors).

Correspondent Banks, NOSTRO Account, VOSTRO Account

 

Correspondent Banks: 

• Correspondent bank is financial institution acting as a third-party intermediary between domestic and international banks.
• Correspondent bank acts as an agent of a foreign bank to conduct business transactions with the domestic bank on its behalf.
• Domestic bank will work with a correspondent bank to set up a Nostro account - meaning our account, on your books.
• The foreign correspondent will call the same account a vostro account - meaning your account, on our books.

NOSTRO Account:

• Word “NOSTRO” is derived from the Latin word “Ours”. 
• NOSTRO account is a bank account, that a bank (Let SBI of India) holds in a foreign country’s   bank (Let Citi Bank of USA) in that country. 
• NOSTRO account is used by banks (SBI) to facilitate foreign exchange transactions and to hold funds that belong to their customers who have accounts in foreign currencies (Dollar).

VOSTRO Account:

• Word “VOSTRO” is derived from the Latin word “Yours”. 
• VOSTRO account is a type of bank account that is held by a foreign bank (SBI) at a domestic bank (Citi bank) in the domestic bank’s currency (Dollar).
•  In other words, a VOSTRO account is a foreign bank’s account at a domestic bank.
• Actually the account remains same but what differs is the nomenclature .

The same account in this case (SBI account in US Citibank ) is NOSTRO to SBI while it is VOSTRO account for Citibank.

Rupee denominated debt, Masala Bond

 Rupee Denominated Debt:

• External debt of India that is denominated in India’s domestic currency, the Rupee. 
• The contractual liability is settled in foreign currency.
• These bonds are beneficial for the borrower in the sense that exchange rate variation risk is  borne by the creditor and not by the borrower. 
• So, the borrower always pays back the foreign currency equivalent of the rupee denomination valued at the spot exchange rate prevailing at that point in time. 

At the time of borrowing:

Creditor (Dollar)-------------------converted to INR------------------- Borrower 

At the Time of giving back:

Borrower (INR)-------------------converted to Dollar------------------- Creditor

In India rupee denominated debt comprises: 

• Rupee denominated NRE account
• Non-Resident Ordinary Rupee (NRO) account,
• Foreign Institutional Investors (FII) investment in Government Treasury-Bills
• Dated and FII investment in corporate debt securities .
• Masala bond 

Masala Bond:

Masala bonds, are first Rupee denominated off-shore bonds, used by Indian entities to  borrowings from overseas markets .

Features :

• These bonds are issued to foreign investors in rupee denominations and settled in US dollars
• Those foreign investors who want to take exposure of the Indian market invest in these bonds. 
• Being Rupee denominated, the currency risk lies with the investor and not the issuer, unlike money  raised in foreign currency loans.    
• It benefits the Indian borrower from currency fluctuation as there is no risk of loss due to rupee depreciation as the issuance of these bonds is in Indian currency rather than foreign currency.

Foreign Exchange Regulation Act (FERA), Foreign Exchange Management Act (FEMA), Liberalized Remittance Scheme (LRS), Foreign Contribution (regulation) Act, (FCRA)

 

FERA to FEMA: 

India has enacted the Foreign Exchange Regulation Act (FERA) and the Foreign Exchange administration Act (FEMA), to govern cross-border transactions, the administration of reserve currencies, and the movement of foreign currency internationally.

Foreign Exchange Regulation Act (FERA):

• FERA came into effect  in 1974 with the provisions of  severe restrictions on currency exchange transactions, including bans on the possession, disposal, and usage of foreign currency. 
• There was control on business dealings between Indian citizens and foreigners. 
• There was provision of harsh fines and provisioning of criminal liabilities in case of  violations. 
• The strict and complex restrictions of FERA discouraged foreign investment and stifled economic growth. 

In order to free up the market and abolish governmental control, FEMA was established in 1991.

The Foreign Exchange Management Act (FEMA):

• FEMA was an outcome of 1991-Economic Reforms and became operative and enforceable in June 2000. 
• Its objectives were to simplify Foreign Exchange limitations, promote Foreign Investment, and ease Trade and payments between nations.
• The main regulatory authority for foreign exchange activities was established as the Reserve Bank of India (RBI). 
• Most of the restrictions of FERA regime were done away with .
• The necessity under FERA for RBI approval of foreign exchange dealings has ultimately been eliminated by FEMA to facilitate the free flow of foreign investments.
• FERA considered violations as criminal offences with the penalty of jail, while FEMA treated breaches as civil offences with monetary fines that could lead to detention for non-payment. 

Liberalized Remittance Scheme (LRS):  

• Introduced on February 4, 2004, Liberalized Remittance Scheme (LRS) allows all resident individuals, including minors, to remit up to USD 2,50,000 freely per financial year.
• This amount is for any permissible current or capital account transaction or a combination of both.

The Foreign Contribution (regulation) Act, (FCRA):

Background of FCRA:

The FCRA was enacted during the Emergency in 1976 when government was apprehensive of foreign powers interfering in India’s affairs by channeling funds through NGO's.

Features of FCRA:

• It regulates the acceptance/prohibition and utilization of foreign contribution by foreign sources.
• All associations, groups, and NGOs that wish to accept foreign donations are required by law to register with the FCRA for 5 years.
• The contributions can be received for social, educational, religious, economic, and artistic goals. 
• It is required to file annual returns similar to those for income tax. 
• Political parties ,media, journalists ,judge ,govt servants are not allowed to receive any funds under this. 
• As per amendments in FCRA in 2020, FCRA rules have become very stringent in the sense that any NGO receiving the funds, though directly not involved with political party but is found engaged in political activities like bandh, strikes will be considered at par with political party for the FCRA reference.

Foreign Currency Convertible Bonds (FCCB),Foreign Currency Exchangeable Bond (FCEB), VRR vs PIS

Examples of Off-Shore Bonds:

Foreign Currency Convertible Bonds (FCCB):

• Foreign Currency Convertible Bonds are offshore Quasi-debt instruments.
• The principal and interest in respect of bond is payable in foreign currency. 
• The issuer is able to convert the bond into stock at a pre-determined conversion rate at which the issuer is granted a certain number of shares. 
• The coupon rates on FCCB’s are generally lower than  bank interest rates, reducing the cost of debt financing. 
• On conversion debt into equity, the debt of company is reduced. 

Foreign Currency Exchangeable Bond (FCEB):

• Foreign Currency Exchangeable Bonds are offshore Quasi-debt instruments.
• These debts are unique in the sense that these debt are exchangeable into equity shares of another  company which is called the Offered Company. 
• The Issuing Company and the Offered Company of an FCEB need to be a part of the same promoter group.
•  The Issuing Company should compulsorily hold the equity shares of the Offered Company at the time of issuance of the FCEB until redemption or exchange of these bonds.

Voluntary Retention Route (“VRR”):

• RBI in 2022 introduced the VRR which  enables FPIs to invest in debt markets in India.
• VRR exempts FPIs from certain macro-prudential and other regulatory prescriptions.
• However, VRR imposes a minimum retention period of three years and the requirement to invest 25% of the committed portfolio size within one month and the remaining amount within three months from the date of allotment.

Portfolio Investment Scheme (PIS): 

• Portfolio Investment Scheme (PIS) is an instrument for Non-Resident Indians (NRIs) to invest in Indian stocks and bonds.
• NRE / NRO Account of an NRI is pre -requisite for PIS.
• There is a ceiling on the number of particular shares in your portfolio investment and the thresholds are set up by RBI and monitored daily. 
• PIS can-not engage in the business of chit funds, agricultural or plantation activities, real estate business related to agricultural or farmland, construction of farmhouses, etc. 
• NRIs are not permitted to carry out any intraday trading or short selling of shares.

Participatory Notes (P-Notes), Offshore bonds vs Onshore Bonds

 

Participatory Notes (P-Notes):

• P-Notes are instruments issued by a SEBI registered Foreign Institutional Investors (FII) to overseas investors, who wish to invest in the Indian stock markets without registering themselves with the market regulator, SEBI. 
• The underlying Indian security instrument may be equity, debt, derivatives or may even be an index.
• They are easy to operate rather than the cumbersome rules that India has for its foreign investors.

 Features of P-Notes:

• The investor in PN does not own the underlying Indian security, which is held by the FII who issues the PN.
• Investors in PNs derive the economic benefits of investing in the security without actually holding it.
• Investors benefit from fluctuations in the price of the underlying security since the value of the PN is linked with the value of the underlying Indian security. 
• The PN holder also does not enjoy any voting rights in relation to security/shares hold through PN.

 Controversary about P-Notes :

• P-notes have been controversial instruments since the very inception as these are freely traded overseas without any control of SEBI.
• P-Notes remain opaque as the identity of the investor is known only to FII and not to the SEBI.
• It is understood that P-notes are being used for money laundering. even by promoters of listed companies.
• Whenever government attempted to regulate them, market start tumbling, which prevents the government to take the harsh step. 

Participatory Notes Crisis of 2007:-- 

On 16th October 2007, SEBI proposed curbs on P-Notes but mere proposal resulted in sharp fall of 1744 points on 17th October 2007 followed by further volatilities.

Offshore bonds: 

                                

• Raising of debt by Indian Companies from global market in Rupee denominated /Dollar denominated is referred to as Offshore bonds. 
• It enables borrower to have access to foreign currency investments.
• These bonds are subjected to different tax rules depending upon tax treaties between countries.
• Offshore markets exposure may induce improvements in domestic bonds markets such as strengthening of domestic market infrastructure, improving investor protection and removing tax distortions that hinder domestic market development etc.

Onshore Bonds: 

                                           

• Onshore bonds are issued by financial entities to raise money from the investors located within the borrower 's home country.
• It is typically in local currency.

Foreign Exchange Reserves, Reserve Tranche Position

 

Foreign Exchange Reserves:

• Assets held as reserve by a central bank in the form of foreign currencies, Gold and  SDR .
• RBI is the custodian of FOREX and  has the primary responsibility of collection, compilation and dissemination of data relating to foreign exchange reserves.
• Most of the foreign exchange reserves are held in US dollars.

 India’s Forex Reserve include:

•       Foreign Dollar assets

•       Gold reserves

•       Special Drawing Rights

•       Reserve tranche with IMF

Forex as on Jan 2025 is 629 .5 Billion US $ with the components as mentioned in the image taken from RBI Report:

Reserve Tranche with IMF :

• Out of total SDR contribution of a country, 25% is kept in the form of gold and foreign currencies while 75 % is kept in the form of local currency and this 25 % is referred to as Reserve Tranche.
• This Reserve tranche provides for unconditional drawing right of the country on the IMF.
• The Reserve Tranche Portion (RTP) of the quota can be accessed by the member nation at any time. 
• This RTP amount remains with IMF and is available as per the demand of the contributing country without any service fee.

Reserve Tranche Position=

        SDR Quota - Own Currency = Foreign Currency/SDRs paid initially for membership.

*As per website of MOSPI,India’s Reserve Position in the International Monetary Fund is not included as part of foreign exchange reserves as they may not be available on immediate demand, although some countries do include these balances as part of their reserves.But RBI considers reserve tranche as part of foreign reserve.

Objectives of Holding Forex Reserves:

• Reserves provide a level of confidence to markets and investors that a country can meet its external obligations in case of any emergency.
• Forex Reserve provides support system and confidence for monetary and exchange rate management.
•  It Limits external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed. 
• All international transactions are settled in US dollars and are therefore needed to support our imports. 
• It serves as a cushion in the event of a Balance of Payment (BoP) crisis on the economic front. 
• The rising reserves have also helped the rupee to strengthen against the dollar. 

GLOBAL DEPOSITORY RECEIPT (GDR),American depositary receipt (ADR)

 

GLOBAL DEPOSITORY RECEIPT (GDR) :

• Global Depository Receipt (GDR), is a certificate issued by a Depository Bank (Depository Bank of  London) which purchases shares of foreign companies (TCS) and deposits them in their account. 
• GDRs represent ownership of number of  shares belonging to a  foreign company (TCS).
• GDR's are commonly used by investors in developed markets to invest in companies from emerging markets .

To Understand:

Let there is an investor "X" in Britain  & wishes to invest in any INC "TCS"

        Depository Bank of  London will purchase TCS share 

                           ⇓

        "X" will purchase TCS share from Depository Bank of  London

                           ⇓

                  Depository Bank of London will issue GDR to X.

Advantages of GDR to issuing company:

• Increase the accessibility to foreign capital markets,
• Increase in the visibility of the issuing company globally
• Rise in the capital because of foreign investors

Advantages of GDR to investor: 

• Diversification of investment, hence reducing risk
• Providing an opportunity for the investor to invest in foreign companies

American depositary receipt (ADR):

• GDR in case of USA is known as ADR.
• It is a Negotiable certificate issued by a U.S. bank against  shares in a foreign stock (eg stock of any Indian  company being traded at US stock exchange ) that is traded on a U.S. exchange. 
• ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. 
• ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction.

Advantages of GDR for US investor:

• ADRs are an easy and cost-effective way for US investors  to buy shares in a foreign company. 
• They save money by reducing administration costs and avoiding foreign taxes on each transaction. 

Advantages of GDR to issuing company:

Foreign entities get more U.S. exposure, allowing them to tap into the wealthy North American equities markets.

Components of FDI, Horizontal & Vertical FDI, Indirect Foreign Investment

Components of FDI:

• Equity Capital, 
• Reinvested Earnings and
• Intra-Company Loans. 

Equity capital: It is investment in equity.

Reinvested Earnings: These are retained profits on the FDI which are reinvested in the market.

Intra-Company Loans: Borrowing and Lending of funds between parent enterprises and affiliate enterprises.

TYPES OF FDI:

Horizontal FDI:- 

When a company invests in the same industry in totality  in which it operates back in its own country .

Vertical FDI:-

• When a company expands only a part of the production process to another country is referred to as Vertical FDI.
• This fragmentation of business benefits enterprises, since the production costs in other countries can be way lower than the country of origin.

Indirect Foreign Investment /Downstream Investment: 

• Investment by an Indian company (owned / controlled by foreigners) into another Indian entity is considered as Indirect Foreign Investment (IFI). 
• Indian entity which has received indirect foreign investment shall comply with the entry route, sectoral caps, pricing guidelines and other attendant conditions as applicable for foreign investment.