Reserve Bank of India to swap rupees for dollars with domestic banks

The Reserve Bank of India’s $5 billion plan to exchange rupees for dollars with domestic banks will help achieve its twin objectives of decreasing interest rates while at the same time preventing a sharp appreciation in the rupee, analysts said on Thursday.

Analysts said that in a bid to dispatch dollars and pump in rupees, the central bank would conduct its first dollar/rupee buy-sell swap auction on March 26.

The RBI has said that in order to meet the durable liquidity needs of the system, the Reserve Bank has decided to create rupee liquidity for longer duration through long-term foreign exchange buy/sell swap.

Apart from easing cash conditions in the banking system, the swap would create cash availability to borrowers during a rigid re-election race for Prime Minister Narendra Modi’s government.

A. Prasanna, head of fixed income research at ICICI Securities said that this would help achieve multiple objectives including bringing down short-term interest rates for borrowers, helping RBI to mop up lump sum amounts of dollars at one go, infusing liquidity and preventing any sharp appreciation in the rupee in face of a strong pipeline of flows in the near term.

After its key policy rate cut last month, the RBI has struggled to get banks to reduce lending rates due because of tight cash conditions and high deposit rates.

Economic growth has dropped to its lowest level in five quarters, posing a challenge for Modi as he seeks a second term in elections set to be held in April and May.

However, the RBI move could increase fund flows to credit-starved shadow banks which accounted for a third of new loans until September 2018, when debt defaults by an infrastructure lender hit the sector, bankers and analysts said.

Several measures by the government and RBI to ring-fence weak financial institutions and relax funding lines for non-bank finance companies, banks and mutual funds have been reluctant to lend to this sector, adding to the economic slowdown.

The RBI’s measure may pressure reluctant bankers to cut lending rates as funding conditions improve.

After the RBI announcement, the rupee fell 69.78 to the dollar, while the one-year forward premium on the unit in dollar-rupee forward contracts dropped to 3.63 from 3.89.

Traders have said that the 10-year benchmark bond yield was up two basis points to 7.57 percent as the move reduced expectations for bond purchases by the central bank.

As per the arrangement, banks can offer to swap dollars for rupees with the RBI at a premium set by the auction process, which could lower hedging costs for the lenders, traders said.

Traders said such a large swap auction could also be aimed at keeping the rupee from rising sharply on large dollar inflows from deals such as ArcelorMittal’s nearly $6 billion bid for Essar Steel.

A trader of a foreign bank also said that apart from a liquidity measure, this could be considered as a forex move. He added that the RBI is proactively taking steps given that there are so many private equity and acquisition deals in the pipeline.

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