$5 bn swap smartest move of RBI gov

India’s banking regulator’s decision to hold a $5 billion three-year US$/Indian rupee buy/sell swap auction (on March 26) is driving forward premia down, paring the hedging cost of corporations for their overseas borrowings. 

This is one of the many outcomes of the Reserve Bank of India’s (RBI) latest liquidity infusion move through a unique instrument. Indeed, in the past too, the RBI had infused rupee liquidity using this route but that had been done (last time in 2013) in difficult times, when the local currency was under attack. 

This diversifies the liquidity management toolkit of the RBI. A cut in the cash reserve ratio (CRR) or the portion of deposits commercial banks keep with the central bank (on which they don’t earn any interest) is the conventional way of infusing liquidity on a durable basis. The RBI’s preferred way, in recent times, has been the so-called open market operations (OMOs): Buying bonds from the banks and releasing money. 

Through this auction, the RBI will buy dollars from banks and release equivalent amount of money — close to Rs 35,000 crore into the system for three years after which the banks will buy back the dollars from the central bank. To hedge against the likely depreciation of the rupee during this period, the banks will pay the swap cost to be decided at the auction. Even if the local currency depreciates more, the banks’ liability is fixed and the RBI too runs no exchange risks as it holds enough dollar assets and won’t need to buy dollar from the market three years later.

In 2013, when the rupee was fast depreciating against the dollar and India was staring at its worst current account deficit, the banking system mobilised $26 billion through foreign currency non-resident bank account (FCNR-B) deposits to shore up India’s foreign exchange reserves. The RBI encouraged the banks to aggressively mop up such deposits (and get rupee in exchange of that) by offering a hefty discount to the prevailing $/Re swap rate in the market at a special window, kept opened between September 10, 2013 and November 30, 2013. These deposits matured in November 2016.

We need to wait till March 26 to know the cut-off swap rate at the auction. Since the local currency is doing fine and there is no urgency to pile up foreign exchange reserves, the RBI is unlikely to offer any sops to the banks this time. In 2013, it had subsidised the swap cost as the context was different: We needed foreign exchange and the rupee liquidity was an offshoot of that.

During the current fiscal year, the RBI has so far infused close to Rs 3 trillion in the system through the OMO route. Why has it chosen the new tool and what are the benefits?

The liquidity is being kept lubricated through regular bond buying by the RBI but the liquidity deficit will intensify as typically in the run-up to a general election more and more currency seeps into circulation, leaving the system. Besides, corporations are paying their advance tax for the March quarter now. The currency in circulation was Rs 19.87 trillion in January, far more than the Rs 16.6 trillion a year ago. The credit deposit ratio in the banking system has been hovering around 78 per cent for months. This is high but even higher is the incremental credit deposit ratio — more than 100 per cent for quite some time. 

For every Rs 100 deposit, banks are to invest Rs 19.5 in government bonds and keep another Rs 4 with the RBI as CRR. But since deposit growth is tardy, they are using their entire fresh deposit and capital to lend. If this continues, the cost of money cannot come down despite a rate cut by the RBI.

The timing of this experiment is apt as foreign currency has started flowing in through the newly opened voluntary retention route or VRR. The RBI in October 2018 announced this channel to facilitate foreign portfolio investment in the Indian debt market but the scheme, which is pretty liberal, was finalised in early March and it is attracting good flow. Besides, the National Company Law Apellate Tribunal giving the go-ahead to ArcelorMittal’s Rs 42,000 crore bid for the debt-laden Essar Steel will ensure another $6 billion flow. This will push up RBI’s foreign exchange reserves, currently at $402 billion. 

While the new tool will infuse rupee liquidity in the system, it will also bring down the hedging cost for Indian corporations raising money overseas. In other words, apart from generating liquidity, the new tool will also open up alternate source of funding for capital-starved Indian corporations, particularly those that want to make investments in new projects but not getting money from the local banking system. 

This may, however, stiffen the yield curve of government bonds at the longer end even as there should be a liquidity-driven rally at the shorter end. The RBI’s continuous bond buying through OMOs has been keeping the long bond yield low. When the RBI sells dollars to stem the volatility in the foreign exchange market, it sucks out liquidity from the system (for every dollar it sells, an equivalent amount of rupee goes out of the system). And, when it buys bonds through OMOs to infuse liquidity, the yield drops. Why? Purely, a demand-supply game. When the demand for the bonds comes from the RBI, prices increase and yields drop. The OMOs help banks as they are able to get rid of illiquid securities without paying the price for it and make money.

Incidentally, banks’ holding of excess government bonds has come down and many of them many not have enough securities to participate in OMOs. Indeed, they hold close to 26 per cent of liabilities in bonds against regulatory norm of 19.5 per cent but they need a large part of the cushion to conform to the so-called liquidity coverage ratio, leaving little to sell to the RBI.

Given a choice, I think, the new instrument will be a permanent fixture in the RBI’s liquid management toolkit, the level of the rupee determining the frequency of use. The Indian currency is now trading at a level (closed at 69.09 to a dollar on Friday), far stronger than its historic low of 74.48 seen in October 2018. On the metric of real effective exchange rate, it is over-valued, making it an ideal situation for such a cool experiment. I’d say this is the smartest move of new RBI governor Shaktikanta Das since he has taken over.
The columnist, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd. Twitter: @TamalBandyo

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