A swap in time

RBI's new liquidity management tool is a welcome move

The Reserve Bank of India’s (RBI’s) move to provide a swap facility of $5 billion to banks will provide liquidity to them without causing any expansion to the central bank's balance sheet. It has also resulted in forward rates coming down and opens an opportunity for long-term dollar borrowers to hedge at a lower cost. RBI Governor Shaktikanta Das has introduced the liquidity management tool, which was used once in the past by Raghuram Rajan in 2013 to rein in the rupee, which had depreciated a lot in a short period. But that was a different situation, and the measure was an extraordinary one. What Mr Das and team intend to do is to make this swap more mainstream and likely a regular feature.

With this facility, banks will no longer need to deplete their bond holdings to shore up liquidity, and for the RBI, the swap will stop a massive expansion of its balance sheet. It will provide additional liquidity even as the RBI continues with its secondary market bond purchases through open market operations (OMO) in the next fiscal year as well. This fiscal year, the central bank prevented interest rates from increasing by buying 72 per cent or about Rs 3 trillion of the government’s net borrowing from the market. The next fiscal year’s borrowing target is equally stiff at Rs 7.1 trillion in gross and Rs 4.73 trillion on a net basis. Banks cannot buy gilts unless the central bank chips in with liquidity support. Now for the RBI, undertaking open market operations expands its balance sheet, which is bad for a central bank that has mounted a war against inflation and is focused on a better transmission of policy rates. The balance sheet expansion corresponds with increase in money supply, which in turn stokes inflation. To control that, the RBI will have to raise interest rates, which then stifles growth. The central bank is now trying to aid growth through lower interest rates. But unless banks pass it on, a policy rate cut doesn’t hold any significance. In the face of a massive supply of bonds, estimated to be over Rs 14 trillion, including state development loans, public sector undertaking bonds, central government borrowing, and corporate bonds, the RBI’s continued liquidity support in the next fiscal year would be a must. Therefore, it is necessary to expand liquidity tools.

The swap of dollars with rupees works only when there is adequate dollar supply in the economy. The month of March, with $4.6 billion net foreign portfolio investments in equity and debt combined, has been promising in this respect. The heat map of the last 12 years shows that the last quarter is always the time when the rupee appreciates due to increased dollar supply. So, the $5-billion swap will likely sail through this time. The expectation of this amount in the near future also means that the RBI’s intervention (purchase of dollars) has reduced in the currency market, which is letting the rupee appreciate. No doubt, exporters who were sitting on dollars have been hit now by the rupee appreciation. The first instance of the swap is expected to be a success as foreign flows have been strong, but how this new tool shapes up in future remains to be seen.