A short explanation of how swaps work may be useful. In a swap, the RBI
may for example, set a rate of, say, Rs 70/USD at the auction (the details of the last swap were confidential). The RBI
pays that rate to pick up the forex. The banks will pay the same rate three years later, when the swap is closed (there may be other terms and conditions as well). Depending on the $/rupee rate three years later, either the RBI, or the banks could make a lot of money.
The banks can lend out the rupees (the RBI may hold much of the forex it receives in hard currency treasury bills). This imparts $5 bn of rupee liquidity to the bond market. One effect of the announcement has been rupee strengthening. The rupee has risen from Rs 71.75/$ in early February to Rs 68.58 this week. There has also been a drop in short-term bond yields.
That gives us a clue as to why the RBI is looking at this instrument. Liquidity in the domestic bond market has dried up since the IL&FS crisis. That has put a squeeze on the non-banking financial companies (NBFCs) and they are the key conduit for lending out to small and medium businesses. Moreover, banks are still struggling to cope with a huge overhang of non-performing assets (NPAs). Given signs that the economy has slowed down — witness poor vehicles sales in January and February — and private investment is low, opening the credit tap may be necessary.
The injection of liquidity ahead of the Monetary Policy Review may be part of a broader plan. This action therefore, gives us a clue about the RBI’s likely stance in April. The Monetary Policy Committee may well decide to follow through with another rate cut. Inflation is genuinely low, even if it has risen slightly in February. The additional liquidity may induce banks to be less cautious about lending out.
Higher domestic liquidity is being coupled to signals that there will be higher global liquidity through 2019. The Fed may keep an accommodative stance, The European Central Bank
and the Bank of Japan
clearly will be accommodative, and so will the People’s Bank of China.
This could mean a global “risk-on” policy with money flowing into equity and other risky assets, regardless of poor earnings growth prospects.
Lower interest rates and more liquidity could help to re-float the NBFC sector, which in turn could mean the resurgence in activity in micro small and medium scale enterprises (MSME). The banking and NBFC sector has already responded to the idea of the swap with a surge to new all-time highs for the Nifty Bank.
The long-term impact on the currency market is hard to judge. In the medium-term, the rupee may be headed for further strengthening and serious over-valuation. A strong rupee encourages imports, and has a negative impact on exports. The trade deficit may rise. Anticipation of a stronger rupee is one reason why the information technology
sector has underperformed in the last fortnight. Traders
would look to be long on the rupee and to switch out of export-oriented sectors and move into financials and rate-sensitive areas.