The Reserve Bank of India (RBI) announced a $ 5 billion dollar-rupee swap auction on Wednesday as part of its liquidity management initiative, resulting in the infusion of dollars and the withdrawal of the rupee from the financial system. The move by the central bank will reduce inflationary pressures and strengthen the rupee.
How does the Dollar-Rupee Swap auction work? An explainer
Treasury officials stated that the move is intended to manage liquidity in the domestic system. This would suck out excess liquidity for an extended period of time while also signalling a further upward push for interest rates on the short end. This will be the second such auction, with the first taking place on March 8, 2022.
According to analysts, the proposed auction on April 26 and one on March 8, 2022, would result in the RBI selling $10 billion and withdrawing rupee liquidity worth ₹75,000 crore.
At a dollar-rupee sell-swap auction held on March 08, the RBI has accepted $5.135 billion against the notified amount of $5 billion. The auction saw three times more bids than the notified amount.
What is a Swap?
A swap is a financial agreement or derivative contract between two parties with the purpose of exchanging cash flows or liabilities. It is a transaction in which one party promises to make a series of payments in exchange for another set of payments from the other side. Swaps usually include cash flows based on notional principal amounts, such as bonds or loans, but the instruments might vary.
What is a Foreign currency swap?
A foreign currency swap, commonly known as an FX swap, is an agreement between two foreign parties to exchange currencies. The agreement entails exchanging principal and interest payments on a loan in one currency for principal and interest payments on a loan in another currency of equal value. A party borrows currency from a third party while simultaneously lending that party another currency.
What is a Dollar–Rupee Swap auction?
In a Dollar–Rupee buy/sell swap, the central bank purchases dollars (US dollars or USD) from banks in exchange for Indian Rupees (INR) and then immediately enters into an opposite agreement with banks agreeing to sell dollars at a later date. In a dollar-rupee sell/buy swap, it sells USD for INR and promises to buy USD from banks after a certain period of time.
In the first leg of the transaction, the bank will buy US Dollars from the Reserve Bank at the FBIL Reference Rate of the auction date. The settlement of the first leg of the swap will take place on a spot basis from the date of transaction and the Reserve Bank will debit the Rupee funds from the current account of the successful bidder and the bidder will receive US Dollars into its Nostro account. In the reverse leg of the swap transaction, US Dollars will have to be returned to the Reserve Bank, to get the Rupee funds back including the swap premium.
Swaps under the auction, once undertaken with the Reserve Bank, cannot be cancelled and no request for any modification or revision to the same will be entertained.
Contract specification of the Dollar–Rupee Swap auction
The minimum bid size set by the central bank was USD 10 million and in multiples of USD 1 million thereafter. The eligible participants can submit multiple bids. However, the aggregate amount should not exceed the notified amount of the auction
The auction cut-off will be based on the premium amount in paisa terms up to two decimal points. Market participants have to place their bids with the premium that they are willing to receive from the Reserve Bank for the tenor of the swap, expressed in paisa terms up to two decimal places. The central bank will accept the Successful bids at their respective quoted premium.
Once the auction window is closed, all the bids will be arranged in ascending order of the swap premium quoted and the cut-off will arrive at the premium corresponding to the notified US Dollar amount of the auction. Successful bidders will be those who have placed their bids below or at the cut-off premium. All bids higher than the cut-off premium will be rejected by the central bank
Why RBI Conduct the swap auction?
The RBI sold $5.135 billion to banks on March 8 and simultaneously agreed to buy back the dollars at the end of the swap settlement period. When the central bank sells dollars, it sucks out an equivalent amount in rupees, thus reducing the rupee liquidity in the system. Dollar inflow into the market will strengthen the rupee which has already hit the 77 levels against the US dollar.
How will RBI’s move impact the rupee and bonds?
Forex swaps are used to manage liquidity. As a result, their effect on currency is only incidental. Nonetheless, in the midst of global tensions and rising crude oil prices, it is critical to keep the INR under control.
The RBI's decision to sell USD in two tranches will keep the rupee volatile and help to limit its depreciation to some extent. The exercise could have a significant impact on the bond market.
The use of swaps for liquidity intervention indicates the RBI's intention to use a different toolkit than traditional ones, leaving room for the central bank to buy bonds when necessary. As a result, bond yields will be limited under the strategy.
Is there a possibility of more such measures?
With the rupee under pressure and inflation posing a serious threat to the economy, the central bank is anticipated to take more steps to control inflation and avert a sharp depreciation of the currency. More RBI steps are expected in the near future, according to the market. "The key to effective liquidity management is 'timing,' as well as a sophisticated and nimble-footed approach that adapts quickly to how liquidity tilts," the RBI said in its policy review on February 10.
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