RBI’s bird in hand is forex swaps but watch out for premium


A bird in hand is worth two in the bush. The Reserve Bank of India’s foreign exchange swaps have in the past been its best bet in managing exchange rate volatility with the added bonus of liquidity management. On Monday, the central bank announced $ 5 billion worth of sell-buy foreign exchange swaps with a tenure of two years.

A sell-buy swap involves two transactions. The RBI will sell dollars in the spot market immediately and simultaneously enter into a contract to buy these back two years later from the forward market. When a central bank sells dollars, it gets back rupees and vice versa.

Through a sell-buy swap, the RBI will end up absorbing rupees and infusing a similar amount two years hence. In other words, rupee liquidity in the system diminishes on an immediate basis but may increase two years later when the RBI takes delivery of dollars under the forward contract.

This operation sits well in the current context of surplus rupee liquidity and the exchange rate needing support amid global volatility.

“With a view to elongating the maturity profile of its forward book and smoothen the receivables relating to forward assets, it has been decided to undertake a sell/buy swap auction,” the RBI said on Monday.

In the current context of volatile global currency markets, the rupee has been fairly resilient. However, as pressures mount because of ongoing geopolitical tensions involving Russia and Ukraine, emerging market currencies are expected to weaken and the rupee won’t be an outlier.

The exchange rate has slipped roughly 1 percent since January but that is lower than the decline of most of its Asian counterparts. Much of the support for the rupee has come from the central bank’s deft intervention in the forex market. From a net buyer, RBI has been net seller since October to offset the pressure of dollar outflows on the rupee.

According to RBI data, the central bank sold $ 2.9 billion in December and currency dealers believe that dollar sales have continued since then.

Yet another fact is the RBI’s own forward contract holdings. The central bank is sitting on close to $ 50 billion worth of forward dollar contracts. Essentially, RBI will buy dollars at various points in the future. More than 95 percent of these purchases would take place between April and December of FY23 because of the maturity profile of these contracts. This would lead to unnecessary pressure on the rupee. The exchange rate cannot afford to be under more pressure as the rupee is expected to weaken this year owing to the US Federal Reserve’s tightening bias. As such, current geopolitical tensions have added an element of risk to emerging market currencies.

Therefore, RBI will offset some of this pressure by selling dollars. In addition to the sell-buy swap, the central bank can enter into forward contracts in the market on a regular basis, currency dealers said.

About Rs 38,000 crore worth of rupee liquidity would move out of the banking system as a result of the forex swap. To be sure, that is not a significant amount given that surplus liquidity is Rs 7 lakh crore even today. Nevertheless, this has resulted in bringing overnight rates within the policy rate corridor briefly.

Like all central bank interventions, forex swaps too carry a flipside. Since the central bank will be buying dollars in the future, the premium for the dollar increases. This, in turn, could make it expensive for importers to book forward dollars. The impact on forward premium rates can be significant.

“We could see the 1y forward spike by around 12-15bps to around 4.20% as a result of the announcement,” forex advisory firm IFA Global said in a research note.

Bps is short for basis points. One basis point is one-hundredth of a percentage point.