Forex Swap and RBI: Benefits and Challenges

Forex Swap (Getty Images)

Recently The Reserve Bank of India (RBI) has decided to inject rupee liquidity into the system through long-term foreign exchange buy/sell swap — a first-of-its-kind instrument used for liquidity management.

Forex swap is different from currency swap where two parties exchange a national principal with one another in order to gain exposure to a desired currency. Forex swaps and other types of foreign exchange operations are also open market operations. OMO is a direct instrument of monetary policy, because the instrument influences the money supply directly. On the other hand, in swap transaction, only authorised dealers, mainly banks, will be allowed to deposit US dollars in exchange for rupees.

In simple terms, In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward) and may use foreign exchange derivatives.

Benefits of forex swap:

1. Swap Auction will increase the supply of rupees in the market and increase liquidity.

2. Dollar swap would help banks to improve their liquidity and will benefit the banks.

3. Using different mechanism would implicitly infuse fiscal discipline

4. This auction is expected to improve fund availability with the banks and in turn moderate borrowing costs, improving credit

5. The decline in forward premium will lower dollar hedging cost for importers.

6. Low premium would attract foreign flows into domestic markets. This also helps to hedge risks of exchange-rate depreciation at low costs and brings stability.

7. The auction will help to boost RBI’s forex reserves by another $5 billion. The forex reserve is one tool which the RBI uses to intervene in the currency market at times of abnormal volatility

Challenges:

1. Only the Category-I banks are allowed to participate in the auction, not all players in the financial services sector will be able to get the benefits.

2. Until now, bond market is preferred route for short term credit adjustment. The success of Forex swap would have a negative impact on bond market

Way Ahead:

This is first time that such a tool has been deployed by the RBI, which has been normally using OMOs to inject liquidity into the system. This would definitely help to meet the durable liquidity needs of the system as many analysts believe that this led to faster monetary policy transmission, unlike the OMOs which is good enough for government bond investors only, but the real impact could be analysed only in coming days.

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