BQ Explains: RBI’s Forex Swap And Its Likely Impact

The Reserve Bank of India will conduct a long-term forex swap auction on Tuesday, aimed at improving domestic liquidity conditions.

On March 13, the central bank had said it will conduct a dollar/rupee ‘buy/sell’ swap auction of $5 billion for tenor of three years on March 26. The auction, if successful, will infuse about Rs 35,000 crore in domestic liquidity.

Bankers and market participants expect the auction to sail through with both domestic and foreign banks likely to bid to swap dollars into rupee. The RBI will easily get the targeted $5 billion with bids at least two to three times of that amount seen likely, said a senior banker while speaking on the condition of anonymity.

How It Will Work

• 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 and simultaneously agree to buy the same amount of U.S. dollars at the end of the swap period.
• Banks would likely bid to swap dollars at a forward rate, which is lower than the market. A cut-off would be determined based on the bids received.
• The dollar funds may or may not be leveraged money, like at the time of the 2013 FCNR deposit scheme.

What Will Be The Impact

The success of the forex swap is being watched closely to see if it could become a preferred tool for liquidity injections by the central bank. This year, the RBI has chosen to infuse liquidity mostly through bond purchases, which many have criticised.

Should the forex swap route be used more frequently, it could have an impact on currency markets, hedging costs for corporates and the bond markets.

Positive Or Negative For Bonds?

For the bond markets, the immediate impact will flow through the channel of easier liquidity. If banks are comfortable on liquidity, the pressure to sell down excess government bond holdings to fund credit growth will reduce. To this extent, the forex swap would be positive for bonds.

Hitendra Dave, head of global banking and markets at HSBC India, sees the swap as slightly ‘bond positive’ as it eases liquidity conditions. Dave does not expect the forex swap to have much impact on the outlook for bond purchases under the open market operation programme. Such purchases were anyway unlikely in the early part of the new financial year due to relatively comfortable liquidity conditions, Dave said.

Others believe that if forex swaps become the preferred route for liquidity operations, bonds will suffer.

Positive Or Negative For Rupee?

There is also debate on whether the forex swap will be positive or negative for rupee.

One set of market analysts believe that the RBI will reduce intervention in the spot market since it is buying dollars via the forex swap. In that scenario, the rupee may appreciate in the spot markets.

Another set of experts believe that since the supply of $5 billion will go directly to the RBI instead of coming into the markets, there will be a “dollar shortage”. The scenario would change if banks are bringing in leveraged funds.

HSBC’s Dave believes it’s neither rupee positive nor rupee negative. The RBI will still continue to mop up dollars from the spot market if it feels the need to, said Dave, adding that $5 billion is a relatively small amount.

Positive For Hedging Costs

One clear positive from the swap is likely to be a decline in hedging costs.

“The market has already priced in the impact through a 40-50-basis-point reduction in the forward premium thus reducing the hedging cost for corporates,” said Jefferies in its note.

While the primary objective of using auction-based forex swap is to infuse rupee liquidity, lower hedging costs could be a collateral benefit, said Shubhada Rao, chief economist at Yes Bank.