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Context
To improve domestic liquidity conditions, the Reserve Bank of India has decided to conduct a long-term forex swap auction.
What is forex swap
- The swap is in the nature of a simple buy/sell foreign-exchange swap with the RBI.
- A bank shall sell U.S. dollars to the RBI, in turn the RBI will pay rupees to the participating banks at the current spot rate.
- Simultaneously, the banks will agree to buy-back the same amount of dollars from the RBI after three years, the tenor of current auction. The final exchange rate will be decided by an auction where banks will bid on the forward premium, they are willing to pay.
If the spot exchange rate is 70 to a dollar, say Bank A quotes a premium of 150 paisa and bids for $25 million. So, the bank will get ₹175 crore ($25 million multiplied by the exchange rate of 70). After three years, the bank has to pay back approximately ₹179 crore ($25 million multiplied by the exchange rate of 71.5) to the RBI to buy back $25 million.
- Forex swap is different from currency swap where two parties exchange a notional principal with one another in order to gain exposure to a desired currency.
- Forex swaps and other types of foreign exchange operations are also open market operations. OMO is a direct instrument of monetary policy, because the instrument influences the money supply directly.
- RBI uses Open Market Operations along with other monetary policy tools such as repo rate, cash reserve ratio and statutory liquidity ratio to adjust the quantum and price of money in the system.
- On the other hand, in swap transaction, only authorised dealers, mainly banks, will be allowed to deposit US dollars in exchange for rupees.
- Under the current swap auction, RBI will buy US dollars from banks totalling to $5 billion. Minimum bid size would be $25 million and in multiples of $1 million thereafter.
Benefits of forex swap
- Increase liquidity in market: Indian financial markets have been undergoing liquidity problems since the IL&FS crisis. In addition to this, the demand for rupees is expected to spike in the coming weeks as a result of a huge spending towards the upcoming general elections. Swap Auction will increase the supply of rupees in the market.
- Boost foreign exchange reserve: The auction will help to boost RBI’s forex reserves by another $5 billion. The forex reserve is one tool which the RBI uses to intervene in the currency market at times of abnormal volatility.
- Improve credit: This auction is expected to improve fund availability with the banks and in turn moderate borrowing costs.
- Benefits Importer: The decline in forward premium (especially at the longer tenor) will lower dollar hedging cost for importers.
- Benefits banks: Banks which currently short on SLR (Statutory liquidity ratio) securities and cannot participate in OMOs. Dollar swap would help banks to improve their liquidity. Also, the cost of dollar swap is less than government securities.
- Fiscal Discipline: Open market operations and sale of government bonds usually used to keep the interest rate lower artificially. Using different mechanism would implicitly infuse fiscal discipline.
- Bring stability: Low premium would attract foreign flows into domestic markets. This also helps to hedge risks of exchange-rate depreciation at low costs.
Issues with forex swap
- Impact bond market: Until now, bond market is preferred route for short term credit adjustment. The success of Forex swap would have a negative impact on bond market
- Limited participation: Only the Category-I banks are allowed to participate in the auction, not all players in the financial services sector will be able to get the benefits.
Way Ahead
This is first time that such a tool has been deployed by the RBI, which has been normally using OMOs to inject liquidity into the system. The RBI’s latest move is in line with its easy monetary policy stance. This would definitely help to meet the durable liquidity needs of the system as many analysts believe that this led to faster monetary policy transmission, unlike the OMOs which is good enough for government bond investors only, but the real impact could be analysed only in coming days.
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