Reserve Bank of India (RBI). (Photo: Reuters)
Reserve Bank of India (RBI). (Photo: Reuters)

Reserve Bank of India’s unusual liquidity tool finds praise in timing, but has exit risks

  • RBI has absorbed a massive 2.8 trillion worth of bonds so far in FY19 through open market operations
  • The most obvious reason RBI did this was to avoid being a back-door fiscal deficit funding source

Every time India goes to polls, the Reserve Bank of India (RBI) scrambles to make sure that banks don’t run out of cash.

That is because cash leakage from banks is faster in the run-up to elections, as shown by the increase in growth rate of currency in circulation.

For a nation trying to get back to its cash levels to pre-demonetization days, before 86% of its notes were rendered invalid, the leakage rate is obviously faster.

But this time, the prescription has an unusual additional pill. RBI will buy $5 billion from banks on 26 March and give roughly 35,000 crore in return, on the condition they buy back these dollars three years later. The premium at which dollars will be bought back will be decided through an auction.

The most obvious reason RBI did this was to avoid being a back-door fiscal deficit funding source, which is what it effectively does every time it buys government bonds to increase the stock of rupees in the system.


The central bank has absorbed a massive 2.8 trillion worth of bonds so far this fiscal year through open market operations. This has made borrowings cheaper for the government, even though the government’s track record of sticking to fiscal discipline has been dodgy. A private corporation would have faced the wrath of the yields for going back on its discipline. But the government has escaped this, because its own banker bought bonds that were equal to 70% of its planned borrowing for the year.

Central bank interventions invariably create distortions in the market. The question is whether RBI is escaping one distortion by making another, by doing the forex swap.

To be sure, swap deals like this are not new. The new aspect is that it has chosen to explicitly make deals through an auction, rather than covert transactions.

So as far as distortions go, this is a good one, believes Ananth Narayan, associate professor of finance at SP Jain Institute of Management and Research. “As a central bank, you have a variety of instruments to manage liquidity and you would use the least disruptive. Compared with bond purchases, this is less disruptive, especially when the rupee is showing an appreciating bias," he said.

Of course, the immediate salutary impact is already visible, with the dollar losing its premium in the forward market. Ergo, hedging costs for any company wishing to borrow in dollars has come down, a welcome relief for corporations facing stiff costs lately.

As prescriptions go, this swap deal comes on top, compared with the modus operandi of managing liquidity through short-term repo operations that RBI followed so far. Hedging is cheaper, and the resultant infusion of rupees would keep a lid on short-term rupee loan rates too. It gets marks for the timing as well and it is a win-win.

But making sure banks have enough money until the cash leakages slow down is one thing, and taking on risk in the future is another.

As its foreign liabilities go up, the central bank is piling on the risk of exit. The last time expiries of swaps came up, getting out wasn’t easy for RBI. In late 2016, when swap deals as part of special scheme of FCNR (foreign currency non-resident) deposits were due, forward premium had risen and the rupee had weakened as banks had to deliver dollars to RBI. The same can play out again in 2022.

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