Apropos Devangshu Datta's column "Now, over to the politicians" (Front Running, September 9), I'd like to correct the impression that the Reserve Bank of India (RBI) is accepting a large share of exchange risk by fixing a swap rate of 3.5 per cent for foreign currency non-resident deposit funds of banks for three-year maturity. There is no exchange risk in the swap mechanism. The RBI would be simply returning the dollars at the end of three years, against rupees received from the banks at fixed exchange rate, with interest at 3.5 per cent per annum. Banks in turn would be returning the dollars to the depositors, or deploying the funds in foreign currency term loans or rupee loans at their own risk.
In the proposed swap, the RBI is only subsidising the swap cost which actually is forward premium determined by market forces. The RBI would be earning only nominal return on its dollar funds - thus the effective cost to RBI is higher.
The swapped dollars do not technically add to forex reserves, since the RBI also has to account for its liability (return of dollars after three years) which sets off the dollar inflow.
Devangshu Datta replies: I made the assumption that nominal rupee treasury yields would remain significantly higher than dollar treasury yields. Right now, the 10-year government of India bond trades at about 8.4 per cent while the US 10-year bond trades at 2.9 per cent. Under the swap terms, If the exchange rate remains unchanged, the RBI loses the difference between available rupee yields and the 3.5 per cent per annum it is offering. This difference is actually the incentive it is offering banks.
If the dollar strengthens, while the yield differential remains the same or similar, the RBI loses because it receives an unfavourable exchange rate when the swap unwinds.
If the dollar weakens, the RBI gains, since it receives a favourable rate when the swap unwinds.
While the swaps don't technically add to reserves, in practice it makes the dollar available for the RBI at a point of time when that may be useful.
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In the proposed swap, the RBI is only subsidising the swap cost which actually is forward premium determined by market forces. The RBI would be earning only nominal return on its dollar funds - thus the effective cost to RBI is higher.
The swapped dollars do not technically add to forex reserves, since the RBI also has to account for its liability (return of dollars after three years) which sets off the dollar inflow.
C Chandrasekhar Mumbai
Devangshu Datta replies: I made the assumption that nominal rupee treasury yields would remain significantly higher than dollar treasury yields. Right now, the 10-year government of India bond trades at about 8.4 per cent while the US 10-year bond trades at 2.9 per cent. Under the swap terms, If the exchange rate remains unchanged, the RBI loses the difference between available rupee yields and the 3.5 per cent per annum it is offering. This difference is actually the incentive it is offering banks.
If the dollar strengthens, while the yield differential remains the same or similar, the RBI loses because it receives an unfavourable exchange rate when the swap unwinds.
If the dollar weakens, the RBI gains, since it receives a favourable rate when the swap unwinds.
While the swaps don't technically add to reserves, in practice it makes the dollar available for the RBI at a point of time when that may be useful.
Letters can be mailed, faxed or e-mailed to:
The Editor, Business Standard
Nehru House, 4 Bahadur Shah Zafar Marg
New Delhi 110 002
Fax: (011) 23720201
E-mail: letters@bsmail.in
All letters must have a postal address and telephone number