The Reserve Bank of India (RBI) has taken a fantastic financial action that will affect the liquidity system of the Indian economy. RBI has announced a dollar-rupee swap settlement for $5 this time there will not be a rollover of this swap, or in simple language, this swap contract will terminate on the date that it matures and RBI would not start a fresh rollover. This action will create a large liquidity effect on the market which would impact the banking system, interest rates and the movement of rupee. It is pertinent to elaborately understand this whole development as there are monetary policy decisions, forex reserve management and inflation targeting strategies behind this.
What is Dollar-Rupee Swap?
Dollar-rupee swap involves the RBI providing dollars to the banks for a specified maturity term and, in turn, takes back equal rupees from the participating banks or vice versa. Once the specified maturity period is completed, these transactions are reversed returning the dollars to RBI and rupees to the participating banks. Dollar-Rupee swaps are generally used to facilitate liquidity, mitigate currency market volatility and efficiently utilize forex reserves. There was a large-scale dollar-rupee swap conducted by the RBI for the first time in 2019 for the stated purpose of providing liquidity to the economy when the liquidity of the market was very tight.
What is the reason for the $5 Billion Settlement?
This time, the amount that comes to maturity is a whopping $5 billion, RDC is a large sum when it comes to maturity. As soon as the maturity date arrives, the RBI will get back dollars at the maturity of the swap, and will inject rupee liquidity in the system. That is, suddenly there will be a burst of liquidity that can lower short-term interest rates. But the important point this time is, that the RBI has explicitly stated that they will not rollover. Rollover is defined as to continue an existing swap contract i.e extend or create a new similar swap, in order to keep the liquidity flow going. This shows that the RBI is looking to cushion short term liquidity temporarily, which would not be available on a continuous basis.
Effect of Liquidity Injection
A liquidity injection of Rs 5 billion creates more money available to the banking system. When liquidity rises, banks will have more money available to lend, and it will tend to lower very short-term lending rates. In turn, this will enable businesses to obtain short-term loans at a lower cost, which may lead to an increase in the level of investment within the economy. A liquidity injection can also create some optimism in the stock market, as a liquidity injection means that investors have more buying power. However, it is useful to keep in mind, excess supply of liquidity can sometimes create inflationary pressures, so RBI will need to be ready to use policy tools after the injection to maintain equilibrium.
Effect on the Rupee
The increase in dollar demand in the forex market will not be significantly high, as the exchange rate shock might not be a surprise anymore to market players because it is a reverse swapped transaction, so that there would be an adjustment in the market before the physical settlement. If, however, the liquidity will affect the sentiments of the economy in a positive way, then it will give some medium-term stability to the rupee.
RBI’s Strategy and Policy Outlook
Although still a significant concern for RBI, inflation is less of a focus right now as domestic and global commodity prices are stable. This leads RBI to signal a more if not all-at-once loosening of overall liquidity. The non-rolling of the dollar-rupee swap settlement is also indicative that RBI does not want to directly address long-term liquidity by rolling the dollar-rupee swap settlement but would add liquidity on a per maturity basis as necessary. Another aspect also will have the forex reserves used more effectively, as on a swap settlement the dollars returned to RBI can be utilized should RBI need to intervene in the foray market at a later date.
Conclusion
We should expect this positive outcome to flow through the banking system, lending rates, stock market and investor sentiment overall. However, in addition to positive sentiment there is also the risk of inflation to consider, which creates a balancing challenge for the RBI. This is a predictable outcome to the forex market, however the sudden liquidity could feed into some positive impulses in the market as well. Overall, this decision is part of the planned sequencing by the RBI whereby near-term the benet of better liquidity has been achieved but also not forgotten about longer-term monetary stability.