Home / Opinion / Columns /  Opinion | Why the Reserve Bank is playing with fire with currency swaps

Important changes are afoot in the Reserve Bank of India (RBI) liquidity management system, and yet this has elicited relatively little serious analysis or scrutiny. Earlier this spring, the RBI conducted a foreign exchange (forex) swap of $5 billion and, on 23 April, a second swap of the same amount.

Like the first, this second swap was oversubscribed, with bids worth $18.65 billion. The bids were accepted at a premium of 8.38, equivalent to an annualized rate of 4.01% (the premium in the earlier swap was slightly lower, at 7.76 rupees). The RBI, in effect, has infused the equivalent of $10 billion worth of rupee liquidity into the financial system, by buying dollars and promising to swap the rupees back into dollars at the pre-specified price in three years.

Supporters of the current government, who presumably approved of the controversial replacement of Urjit Patel by Shaktikanta Das as governor late last year, have praised this innovative new addition to the liquidity management toolbox by the erstwhile bureaucrat-turned-central banker. The RBI has said that the swap window remains open, and more such offerings may occur in the future.

So what’s not to like? Plenty.

As astutely pointed out by columnist Diva Jain, writing in Business Standard on 23 April, the RBI is operating like a hedge fund, taking on considerable interest rate and exchange rate risk, as defined by both the tenure and structure of the swaps. In effect, the RBI is betting both on a falling rupee interest rate and a rising dollar interest rate, in addition to betting against a significant depreciation of the rupee, all within this three-year period. This is a very risky bet and, if it does not pay off, it will suffer considerable financial loss.

Such a trade, whereby the RBI takes on both, its own as well as counter-party risk, is rare even in the world of sophisticated advanced economy hedge funds, such as those on Wall Street, and is almost unheard of among major central banks, who prefer to stick to more conservative liquidity management tools, which assure profit or, at any rate, are not prone to the danger of a large loss. For example, the Bank of Canada, which like the RBI, has an explicit inflation target mandate, rarely, if ever, intervenes directly in forex markets, and manages domestic liquidity through conventional means such as open market operations (OMOs).

The $10-billion question is: Why is the RBI taking on such unnecessary risk, when its conventional and safe tools have worked perfectly well so far? Macroeconomic theory offers the answer. By buying dollars and selling rupees, the RBI, in effect, is hoping that the rupee will depreciate as a direct result of this forex market intervention, and a weaker domestic currency, by making exports more attractive and imports more expensive, is an indirect mechanism to loosen monetary policy, if the conventional interest rate channel is not working. A volatile rupee may also entice “hot" money and carry traders into the market, thus inducing excessive exchange rate movements and capital flows, increasing economic and financial market uncertainty, for sure, with little, if any, upside gains.

As a former central bank official cannily noted to us, the forex swaps amount to a form of “quantitative easing" through the back door.

Let’s connect the dots. The RBI’s Monetary Policy Committee (MPC), since Das has taken over as governor, has twice reduced the repo rate by 25 basis points (half a percentage point in total). Yet—and this is the crux—there has so far been a remarkable failure of pass-through to key interest rates in the economy, such as the G-Sec (government security) yield curve, especially for longer maturities, nor much, if any, reduction in benchmark borrowing and lending rates by large commercial and public sector banks. In other words, the monetary transmission mechanism, which is crucial if inflation targeting is to work as intended, has failed.

It seems very likely that the RBI is using these exotic forex swaps, not principally to boost domestic liquidity, as they claim, but rather to act as a surrogate to loosen monetary policy, in the absence of a well-functioning conventional interest rate channel. In the face of uncertainties about rising future inflation, and inflationary expectations, and with the economy operating near “full employment" (the employment level after which price levels start rising), such a policy can only lead to an overheating of the economy in the medium to longer run in return for an uncertain fillip to economic activity in the short run. If there does not appear to be a credible economic rationale for the supposedly expansionary effect of the forex swaps, there is an obvious political rationale. In the middle of a tightly contested election campaign, in which conventional policy moves that might boost the economy are disallowed by the Election Commission of India, such as those relating to fiscal or regulatory policy, nothing rules out the use of monetary policy, whether conventional or unconventional.

While the RBI is formally at an arm’s length from the government, in particular the ministry of finance, it actually exercised this distance during the tenure of Patel across a range of its domains, especially in not buckling under political pressure to lower interest rates. Das’s RBI is a different creature, looking and acting the part of a willing and pliant arm of the treasury. We will all suffer greatly as a consequence, with more erratic and higher inflation, with no long-lasting boost to economic activity—though well after the election is over.

Vivek Dehejia is a Mint columnist. Rupa Subramanya is a Mumbai-based economic researcher and writer.

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