RBI weighs $ sell-buy swap to stem liquidity

The Reserve Bank of India (RBI) is exploring the use of a dollar sell-buy swap to drain liquidity from the banking system, having used the most common instruments over the last two and a half years in its fight against inflation.

It is now examining whether sell-buy swaps in the foreign exchange market could postpone the creation of rupee liquidity immediately after its intervention in the foreign exchange market. The swap involves selling dollars with a simultaneous agreement to buy them back at a future date at a specified price.

The RBI has to try out newer ways of liquidity sterilisation as the limit for absorption under its market stabilisation scheme is close to hitting the ceiling.

Also, the central bank has already used the cash reserve ratio (CRR), the amount of cash it requires banks to deposit with it, aggressively since December 2006, raising it by 150 basis points to 6.50 per cent.

The RBI is seeking to experiment with sell-buy swaps as it needs to absorb rupees injected into the system because of its dollar purchases to stem the rupee's appreciation. The rupee has appreciated by around 10 per cent since January 2007.

Under the swap, the RBI will buy dollars from the market and sell them the same day. While selling these dollars back into the system, it will book a contract with the buyers to buy the dollars back at a specified price on a future date (basically a forward contract).

When the time comes to buy these dollars from the market, the RBI can review the liquidity situation and either roll over such swaps or convert the dollars into rupees.

These swaps, however, would prove counter-productive if the bank buying the dollars sold by the RBI through sell-buy swaps lends the money to customers to meet rupee expenditure.

If such loans are not hedged, they come back into the system, forcing the RBI to intervene again. Therefore, there would be multiple swaps on the same base of foreign exchange bought by the RBI.

To check such a spiralling effect of sell-buy swaps, the RBI is proposing to enter such deals for very short periods of a few days to a few weeks, which would make it unattractive for companies to buy dollars this way for further commercial lending.

The RBI's experiment with sell-buy swaps is to see if the dollars sold could be used by banks to meet the requirements of their overseas branches or subsidiaries.

The cue has been taken from central banks like those of South Africa and Australia that use such swaps to postpone liquidity creation generated by capital inflows and consequent accretion of reserves.

A similar exercise was undertaken by the RBI to spread out the payment of dollars to banks during the redemption of the Resurgent India Bonds in 2003, to prevent volatility of the rupee-dollar exchange rate. But this had led to build-up of pressure on the market to meet deliveries.

Also, the report of the working group on instruments of sterilisation of liquidity had stated that while limited use of sell-buy swaps for very short periods may be useful, any decision to use this instrument extensively has to be taken with due care and circumspection.