Question

What is the risk of reducing the foreign US currency by Australia when the monetary policy utilises forex swaps more than domestic repos? Explain your working and answer in words.

Answer 1

A foreign currency swap, also known as an FX swap, is an agreement to exchange currency between two foreign parties. The agreement consists of swapping principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency. One party borrows currency from a second party as it simultaneously lends another currency to that party.

Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds.

The risk of reducing the foreign US currency by Australia when the monetary policy utilises forex swaps more than domestic repos is that in using FX swaps, the australian govt is borrowing USD and lending australian dollars. So in case of an inflation, it would find it hard to reduce the money supply because reducing foreign US currency further involves exchange rate risk. whereas if it used repo rate, central bank could increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.