RBI dollar swaps: Into the unknown

Compared to standard liquidity management tools that are usually profitable, RBI takes on considerable macro risk with the swaps

The Reserve Bank of India (RBI) has been the cynosure of media attention recently and financial commentators have heaped high praise on it for “innovative” liquidity management through a highly successful dollar swap auction. Emboldened by the response, the venerable central bank has now announced a second tranche to be auctioned today (April 23). Normally, one expects little attention to be given to routine liquidity operations of central banks but RBI’s actions are neither routine nor limited to purely liquidity management. Under the innocuous wording of dollar swaps hides an exotic beast rarely seen even in the densest jungles of developed capital markets.

 
The rarity of the beast unleashed by RBI and its attractiveness to many financial agents, as witnessed by the heavily oversubscribed offering in March, lies in two main features — tenure and structure. RBI’s swaps are three years in tenure. This means that RBI is giving bidders rupee in return for dollars at current exchange rates with a promise to return those dollars in three years at the same exchange rate. In return for this facility, RBI is charging a fee, called the spread, to be determined at the auction. For the March auction, the spread was 776 paise and the spot exchange rate was Rs 68.86 for each dollar. In other words, the RBI paid rupee to banks in exchange for dollar at the rate of 68.86 and promised to return those dollars in three years at the rate of 68.86+7.76 = Rs 76.62 for each dollar. This is an economically complex transaction whose structuring and tenure can have significant financial ramifications for the RBI.

 
A sword of Damocles with interest rate and exchange rate risk as its two edges hangs over what is essentially a hedge fund trade by the RBI. By accepting dollar in return for rupee in the swap, RBI forgoes the income it could have earned by lending in rupee terms. If it deploys the dollar inflow, it will earn the dollar interest rate which is currently much lower than the ruoee interest rate foregone for a period of three years. If the rupee interest rates rise in the next three years, RBI would have foregone higher potential income and thus suffer a loss. Conversely, if the dollar interest rate rises in the next three years, RBI will earn more on the dollar deployed and incur a gain. Therefore, by entering the swap the RBI is essentially betting against rising rupee interest rates and in favor of rising dollar interest rates.

 

This would have made sense if interest rates were predictable and stable. Unfortunately, modelling and forecasting interest rates is one of the most challenging problems in finance. It is for this reason that only the most sophisticated hedge funds with armies of MIT PhDs trade interest rate risk. Jointly modelling rupee and dollar rates is even more herculean and the long three-year-tenure of RBI’s swaps makes it immensely more complicated thereby making one wonder what makes the RBI so confident about taking joint exposure to dollar and rupee rates.
 
The second source of risk is the exchange rate. The RBI has promised to pay back the same amount of dollars after three years. If there is a precipitous decline in the rupee against the dollar, RBI will end up losing a significant chunk of money. Thus with this trade, RBI is betting against rupee depreciation. Again, modelling exchange rates for three-year-tenure is a non trivial exercise for even the most hardened egg heads and jointly modeling it with interest rates is impossibly complex.

 
It is for these reasons and the “unique” structuring of this “swap” that such a transaction is rarely offered by seasoned hedge funds and investment banks.  Most cross currency swaps are non deliverable — meaning no cash is exchanged either at initiation or completion of the swap term. Counterparties do not physically exchange the currencies being swapped. This is done to reduce transfer and counterparty risk. RBI’s swap on the other hand is deliverable, meaning that RBI will actually hand out rupee in exchange for dollar, thereby taking on counterparty risk (risk that banks may not pay back rupee after three years). This makes it a fairly rare beast in the swap world. While RBI is getting compensated in the form of the spread there is good reason why sophisticated investors rarely dabble in such transactions and limit their involvement to forwards and standard swaps.

 
Thus, compared to standard liquidity management tools like OMOs and repo transactions that are low risk and usually profitable, the RBI is taking on considerable macro risk with the swaps. While innovative, one can argue that this is high stakes casino style liquidity management which we saw the Fed indulge in at the peak of the 2008 financial crisis. By shunning its image as stodgy “babu bankers” and marching in to territory where hedge funds fear to tread, Mr Shaktikanta Das has boldly gone where no RBI chief has gone before. While the results of this enterprise will be clear only after three years, in the meantime, the behaviour of this exotic beast created by the RBI will continue to worry fans of Mary Shelley and students of financial history.

 

The author is a “probabilist” who researches and writes on behavioral finance and economics