U.S. dollar and Indian rupee banknotes are arranged for a photograph in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

RBI’s Forex Swap Auctions And The Law Of Unintended Consequences

BloombergQuintOpinion

The Reserve Bank of India has now gone through two rounds of forex swap auctions to infuse liquidity into the domestic markets. Over the auctions—conducted in March and April—RBI has pumped in close to Rs 70,000 crore. This has supplemented the liquidity added via bond purchases at a time when the system continues to operate at a deficit of over Rs 1 lakh crore.

The new forex swap facility has brought with it some surprises and unintended consequences and, as a senior RBI official recently admitted in an off-record conversation, even the central bank is learning as it goes along.

Here are some learnings from the two auctions, starting with the most recent one.

Learning 1: Beware Of The Corporate Treasury Smarts

The long-term forex swap has opened up a new window for corporates to hedge their external commercial borrowings. And it appears one company made full use of this opportunity at the auction on April 23.

The auction was for an amount of $ 5 billion – similar to the first one that concluded on March 26.

Participants were invited to bid to swap dollars for rupees for a three-year period. They would bid based on the premium they are willing to pay the RBI for the swap. Based on the bids received, the RBI would determine a cut-off premium. Limits are allotted to those who bid higher than the cut-off.

In the first auction held on March 26, the RBI received bids worth $16.31 billion. The cut-off premium was set at 776 paise at that auction. 89 bids were accepted and the $5 billion was allocated across those bids.

The first auction was seen as a success. Apart from the fact that the RBI managed to get the planned $5 billion dollars and infuse about Rs 35,000 crore in rupee liquidity, hedging costs declined. The all-round view was that more such auctions would follow.

On April 1, the RBI announced the second forex swap auction. This time with a lag of almost a month. An auction of $5 billion will be held on April 23, the central bank said. The rule of the game remained the same.

One of India’s largest corporates, with significant overseas debt and dollar borrowings, used that window of opportunity to raise more than $2.5 billion in the intervening month, said a senior treasury official at a large bank. This corporate, which has a large export-import business, also had underlying dollar exposure some of which was unhedged.

Ahead of the auction, the MIFOR (Mumbai Inter-Bank Forward Offer Rate) swap rates in the market were running in the range of 6.10-6.20 percent. Most were expecting the swap to take place at a small discount to the prevailing market rates. Many clients were waiting to see the auction results before swapping dollars in the market because they expected some savings if allotted limits in the auction, said the official quoted above.

However, the incentives for this one corporate were perhaps different.

The corporate had borrowed funds linked to LIBOR rates and even at a swap cost higher than the market, the cost of dollar funds was working out to be lower than the cost at which it could raise money in the local market. As such, for this corporate, the incentive was not so much the cost saving via the swap window but the ability to hedge a large dollar exposure at one-go. The rupee liquidity it would receive could be used to retire some local high cost borrowings.

Market participants believe that this corporate, through its banks, bid for the entire $5 billion, at a premium much higher than what was expected.

A Bloomberg poll ahead of the auction had pegged the premium cut-off at 790 paise. But the actual cut-off came in much higher at 838 paise. In percentage terms, this worked out to a MIFOR swap rate of around 6.35 percent.

When the auction results were declared, it turns out that 255 bids worth $18.65 billion were received by the RBI.

Five bids worth $5 billion were accepted.

Trading rooms are rife with speculation on who this corporate is. BloombergQuint is not naming the corporate since it could not get direct confirmation that the transactions were indeed conducted on behalf of this corporate.

An RBI official, who spoke on condition of anonymity, said they are aware of the dynamics of the auction. It is a new instrument for us too so we will continue to learn along the way, this official said.

An email sent to the RBI on Friday was not answered.

Learning 2: There Is A ‘Cash-Tom’ Rate And It Matters

There have been other learnings, too.

At the end of the first auction, the ‘cash tomorrow’ rate spiked. This rate, referred to as ‘cash-tom’ in the trading world, is essentially the rate of swapping dollars to rupees on the next working date.

After the last auction, this rate spiked.

Different treasury officials attributed different reasons to the spike in the ‘cash-tom’ rate. Some said the spike in rates was due to a combination of factors such as year end and the excess dollar supplies. With only $5 billion of the $16 billion in bids accepted, the remaining dollars were available to swap into rupees and banks were willing to pay a premium to book those transactions.

Others said it was also due to the RBI’s large-exposure framework kicking in. Exposure that local branches of foreign banks have to the parent would fall under this framework. This led to some excess dollar supplies from foreign banks.

The spike in demand to swap dollars into rupees, in turn, provided an arbitrage opportunity for those with access to rupee funding. And so, we saw a surge in demand for funds in the overnight inter-bank call money market, which pushed up rates there.

Learning 3: Mix And Match

In FY19, the RBI bought nearly Rs 3 lakh crore in government bonds under its open market operation programme. Many said this was distorting rates in the bond market and that the RBI was effectively monetising the government’s deficit.

Now that it has moved to introduce forex swaps, questions are being asked about distortion in the forex markets and whether some corporates have ended up benefiting disproportionately.

As such, for the RBI, the bigger learning is perhaps that it is best off working with a few instruments to infuse liquidity rather than relying on any one. Incidentally, right after the second auction was concluded, the RBI announced another round of bond purchases. The window for more forex swaps also remains open.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.