BL Explainer: RBI’s Dollar–Rupee swap auction and its rationale

What is a Dollar–Rupee Swap auction?  It’s a forex tool whereby the central bank uses its currency to buy another currency or vice versa. In a Dollar–Rupee buy/sell swap, the central bank buys dollars (US dollars or USD) from banks in exchange for Indian Rupees (INR) and immediately gets into an opposite deal with banks promising to sell dollars at a later date. In a dollar–rupee sell/buy swap it sells USD in exchange for INR and promises to buy dollar from banks after some years.   Why do Central Banks engage in it?  Forex swaps help in liquidity management. It also, in a limited way, helps in keeping the currency rates in check. A dollar–rupee buy/sell swap injects INR into the banking system while sucking out the dollars, and the reverse happens in a sell/buy swap. What is the RBI planning to do on March 8?  The Reserve Bank of India has announced a two-year sell/buy swap auction of $5 billion. The auction date is set for March 8, and the spot date or the date on which the transaction must be settled is March 10. On March 10, the RBI will sell USD 5 billion to banks that have bid at the lowest currency premium. The intent here is that the central bank acquires dollars from the seller, charging the lowest premium possible for the two-year tenor. Accordingly, banks that bid at the lower range of the auction are successful at the auction. Assuming a dollar rate of Rs 75, the system liquidity will shrink by Rs 37,500 crore. RBI has a two-year window to buy back these dollars.  Why is RBI resorting to it now?  Surplus liquidity in the system is pegged at Rs 7.5 lakh crore, which needs to be curbed to keep a tab on inflation. Usually, the central bank will resort to traditional tools such as increasing the repo rate or increasing the cash reserve ratio (CRR), but this can have a negative implication on the economy. Therefore, the RBI used a different toolkit - variable rate reverse repo auction (VRRR) last year. However, the recent VRRR auctions were undersubscribed by banks, as the cash market offered instant and better yields, forcing the RBI to consider a longer-term liquidity adjustment tool such as forex auctions. Interestingly, apart from March 10, the far leg of March 13, 2019’s three-year USD–INR buy/sell auction falls due on March 28, 2022. This again is a USD 5 billion swap, where RBI will sell dollars to banks. With two sell auctions at play in March, nearly Rs 75,000 crore of surplus liquidity could be sucked out of the system.  How will RBI’s move impact the rupee and bonds?  Forex swaps are intended for liquidity management. Therefore, their impact on currency is only incidental. That said, amidst global tension and hardening crude oil prices, it’s important to keep INR under control. The RBI resorting to selling USD in two tranches will keep a check on Rupee’s volatility and help curb its depreciation to some extent. For the bond market, the exercise may have a pronounced impact. Bonds yields are already on an incline. Liquidity intervention through swaps indicates the RBI’s plan to use a different toolkit rather than the traditional ones, and this leaves room for the central bank to buy bonds when needed. Consequently, the strategy will contain bond yields. Is a dollar swap normalisation by stealth?  Yes, to an extent. It allows the regulator to normalise the maturity pattern of its dollar assets. At present, the risks involved in adopting traditional methods is nudging the RBI to roll out forex swaps, maybe later, even the open market operations. However, RBI’s move should also be seen in the context of a likely forex inflow into the Indian capital markets, thanks to LIC’s initial public offering round the corner. Touted as the largest public issue so far, it is estimated that Rs 40,000–45,000 crore of foreign money could hit Indian equities, possibly having a near-term bearing on INR. The two USD sell auctions scheduled this month could likely take care of this temporary rupee volatility.  Will the government gain from the swaps?  Just like how companies gain or lose from forex swaps, RBI’s may benefit or otherwise too. With USD 10 billion to be sold in March, the gains could be significant. Going by the experiences in 2019 and 2020, when the cut-off premium for the bids were 840 – 845 paisa, the likely gains from the swap auctions could be around Rs 8,400 crore. Usually, in May, RBI makes its dividend payment to the government for the previous fiscal. The surplus from these swaps could pad up the pay-outs. 

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