Last week’s rupee-for-dollar swap auction carried out by the Reserve Bank of India (RBI) has reportedly been an even greater success than its first such exchange last month. As many as 255 bidders offered to place $18.65 billion (around ₹1.3 trillion) with the central bank, more than three times the $5 billion it had said it would accept. The premium that winning bidders offered for the 3-year currency swap rose to ₹8.38 from ₹7.76 in the March auction. Clearly, currency swap as a tool to inject liquidity into the system has found favour with banks and companies. Robust demand has established it as a new arrow in RBI’s quiver to ensure there is enough money to go around. But while market participants starved of cash are pleased and keen on further auctions of this kind, RBI needs to be careful that it doesn’t rely too much on this seldom-used instrument, given the risks it bears on such transactions.
Under the swap deal, dollar-surplus entities in need of rupees turn in their greenbacks to RBI and get the Indian currency equivalent on the agreement that this trade will be reversed three years later; that is, they get those dollars back, though they must pay RBI a premium— ₹8.38 by the latest auction—over the dollar’s current rate for this facility. On paper, this fee accounts for the fact that rupee loans attract a higher rate of interest than dollar loans, so the gap between the two is like an “interest" charged by RBI for lending them the more remunerative currency. The premium, though, is greater than this gap. This is because the deal involves currency risk—on both sides. Those giving in dollars are betting that the US currency will rise against the rupee by more than ₹8.38, so they’ll get their dollars back cheaper. Conversely, if the dollar falls over the three-year span, then it will be RBI that gains on the transaction. Although currency projections are hard to make accurately so far ahead, the odds of the dollar going up look brighter on current macroeconomic trends. Between the last swap and this one, the rupee’s vulnerability to rising oil prices has increased, which partly explains why the swap premium has risen. In general, RBI looks like it will end up on the losing side of the deal. It could be argued that its aim is not profit, but easing of liquidity conditions. Still, there is another risk it bears—that of interest rate uncertainty. If the difference widens between the rupee and dollar lending rates, which could happen if a fiscal blowout makes Indian credit expensive, then the swap fee would be too little to make up for the interest earnings that RBI would have forgone on rupee debt.
These risks have made observers wonder why RBI didn’t settle for conventional bond buybacks to pump money into the economy. To be sure, buying government bonds for the purpose is not always feasible, since banks are required to hold a minimum level of these and have little left for such transactions. To everyone’s surprise, however, soon after last week’s currency swap, RBI announced ₹25,000 crore worth of bond repurchases in May. These will help ease the cash crunch further. Perhaps they are also a sign that the central bank doesn’t intend to get too adventurous with swaps. It would be best if an appropriate balance is struck between the two liquidity tools. The central bank could do without an overload of liabilities due in 2022.