Dollar-Rupee Swap
GS Paper – 3 Growth & Development, Monetary Policy.
Why is it in the news?
- A USD 5 billion dollar-rupee swap auction was recently held by the Reserve Bank of India (RBI) as part of its liquidity management effort, according to the bank. This will result in an influx of dollars into the financial system, while the rupee will be sucked out of the system.
- The rupee will gain as a result of this, since the pressure on inflation would be relieved.
What is a Dollar–Rupee Swap auction, and how does it work?
- It is a foreign exchange trading technique in which the central bank utilises its own currency to purchase another currency or vice versa.
- A Dollar–Rupee Buy/Sell Swap is a transaction in which the central bank purchases dollars (in this case, US dollars or USD) from banks in exchange for Indian Rupees (INR) and immediately enters into an opposite transaction with banks pledging to sell dollars at a later date.
- Selling dollars and buying rupees is referred to as a dollar–Rupee sell/buy swap. When the central bank sells dollars and buys Rs, it sucks out an equivalent amount in rupees, hence diminishing rupee liquidity in the economy.
- Because the conditions of the swap transactions are predetermined in advance, there are no exchange rate or other market risks associated with them.
What does the Reserve Bank of India want to do?
- The Reserve Bank of India sold USD 5.135 billion in dollars to banks while also agreeing to purchase back the dollars at the conclusion of the swap settlement period.
- Here, the goal is for the central bank to obtain dollars from the sale while charging the seller the lowest feasible premium for the two-year tenor.
- As a result, banks that bid at the lower end of the auction’s range are successful in winning the auction.
- If the dollar rate is 75 rupees per dollar, the system’s liquidity will be reduced by Rs 37,500 crore.
What is the reason for the RBI’s decision to use it now?
- The amount of excess liquidity in the economy is estimated to be Rs 7.5 lakh crore, and it must be curtailed in order to keep inflation under control.
- Typically, the central bank would turn to traditional tactics such as raising the overnight lending rate (repo rate) or boosting the Cash Reserve Ratio (CRR), although this can have a detrimental impact on the economy.
- It is possible to discern the negative implications of this through the imperfect transmission of monetary policy.
- Last year, the Reserve Bank of India (RBI) employed a different toolbox, the Variable Rate Reverse Repo Auction (VRRR).
- Although the previous VRRR auctions were undersubscribed by banks since the cash market provided quicker and greater rates, the RBI is considering using a longer-term liquidity adjustment instrument, such as FX auctions, to address the undersubscription problem in the future.
What is the ramifications of the swap?
Reduced Liquidity: The most significant ramifications would be a reduction of liquidity, which is now estimated to be roughly Rs 7.6 lakh crore.
Dollar inflows into the market would support the rupee, which has already reached the 77 level versus the US dollar, therefore halting its depreciation.
Inflation Control: When inflation threatens to increase substantially, the Reserve Bank of India (RBI) often reduces liquidity in the economy. Inflation is expected to grow as a result of the following factors:
- Inflation is expected to grow in the next days as a result of the substantial increase in crude oil prices as a result of the Russia-Ukraine conflict.
- Outflow of Institutional Investments: Foreign portfolio investors have started withdrawing money from India in recent months. So far in March 2022, they have withdrew Rs 34,000 crore from Indian stocks, exerting significant downward pressure on the rupee’s value.
What is the Liquidity Management Initiative, and how does it work?
- When it comes to a central bank’s “liquidity management,” it is defined as “the framework, set of instruments, and, most importantly, the rules” that it uses to steer the amount of bank reserves in order to control the price of those reserves (that is, short term interest rates) in accordance with its ultimate goals (e.g. price stability).
- Bank reserves are the bare minimums of cash that financial institutions must keep on hand in order to fulfil the criteria of the central bank.
- In monetary policy, the Reserve Bank of India uses the Liquidity Management Initiative, which allows banks to borrow money through repurchase agreements (repos) or for banks to lend money to the RBI through reverse repo agreements.
Among the several instruments that fall under this framework are:
- Auctions for repo and reverse repo
- Standing Facility on the Periphery (MSF)
- Swaps in the Foreign Exchange Market
