A new, effective tool

Recently, on March 7, the value of Indian rupee vis-à-vis USD had hit a historic low. The obvious reason being extraordinarily high international crude oil prices. Given that oil, as a source of energy, is known to have a wide-ranging impact on the prices of a host of other commodities, the chances of steady and high inflation are also being enunciated. High inflation, as is known, is an economic condition where the value of currency is on a decline on account of excessive liquidity. India's banking sector regulator, the Reserve Bank of India (RBI), conventionally uses policy techniques such as modifying the repo rate, reverse repo rate or Cash Reserve Ratio (CRR) to contain excess liquidity. But these policy tools have their own set of economic shortcomings. The RBI also uses bond markets to regulate liquidity in the economy. The Central Bank now appears to be significantly inclined towards using forex swaps as a liquidity regulation tool. It successfully used forex swaps in 2019 and 2020 and is now using it in 2022. Forex swaps can be categorised into two categories for the sake of understanding — a buy/sell swap and sell/buy swap. In a buy/sell swap, the RBI injects Indian Rupee into the market by buying dollars from the banks that may be holding forex reserves without much use. The transaction has a swap settlement period by the end of which the RBI is supposed to reverse the transaction with respective banks. Buy/sell swaps are critical when the economy is facing a liquidity crunch. Sell/buy swaps, on the contrary, involves the RBI selling US dollars to the banks with the promise of buying back by the end of the swap settlement period. In doing so, the RBI sucks out the excess currency in the market for the time being. The recent swap auction that RBI successfully conducted earlier this week falls into this category. As inflation is bound to get high in coming days, leading to excess liquidity, this move appears to be a positive one. As of now, the surplus liquidity in the currency market stands at an astounding Rs 7.5 lakh crore. The recent sell/buy forex swap is expected to suck out around Rs 35,000 crore from the economy. It must also be noted that the RBI held a buy/sell forex swap of USD five billion in March 2019 with the settlement swap period of three years ending this month. As the Central bank will reverse the transaction by selling the dollar it had bought from the banks in 2019, more surplus currency will be pumped out of the economy. Combining the transaction of both the swaps, a total of around Rs 75,000 crore of surplus liquidity will be pumped out. This is indeed a significant relief and will certainly stabilize the depreciation of the rupee to a certain extent. Understanding the limitations of the traditional methods of balancing liquidity, the RBI had also tried to use Variable Rate Reverse Repo (VRRR) but that went quite unpopular with the banks. The forex swap mechanism may turn out to be helpful for banks as well because it allows them a window for creative management of their forex funds. Furthermore, as India is set to carry out big disinvestment projects, including the massive LIC listing, the country is set to witness heavy inflow of foreign funds into the economy. The recent forex swap will also potentially offset some of the possible negative effects of this inflow by strengthening the Indian rupee. In sum total, forex swap, in the short run, appears to have the potential for tackling the concerning issue of weakening rupee. At the same time, it is apparently clear that RBI sees it as an effective liquidity regulation tool in the longer run also. The bond and currency market may face the impact of such a move but creative solutions need to be found for effective management over a period of time.