Dollar Currency Swap by RBI

RBI is central bank of India and it uses liquidity management tools like

a)      Repo

b)      OMO (Open market operations) etc.

Recently, RBI used another tool – Currency swap

Effects/Aim:

To infuse liquidity to overcome the current liquidity crunch.

The rupee appreciation may slow.

The dollar reserves of RBI increases.

How does it work?

RBI gives rupees for which banks gives dollars to RBI under certain terms and conditions. This contract is for a period of 3 years and the banks have to pay a forward premium. The banks (Tier 1) can participate in auction for the 5 billion dollar.  The banks will buy back dollars after 3 years at rates arrived through auction.

The content below can be ignored by aspirants. It is for causal readers of this blog.

What are risks of the currency swaps?

The swaps have default risk and exchange risk. In this case, since RBI is central bank, it can avoid default risk.

How is the swap agreement made?

As in most financial contracts, reasoned assumptions are made regarding the economy and then scenario analysis is done. The risk management analysis based on cash flows and assumptions in exchange rate, policies which may be followed by banks etc are done to arrive at a decision making.

How is liquidity created?

Banks which get rupee pass it on to its customers.

The customers could be

a)      Old customers –

1.       Those who repay

2.       Those who default due to business risk

3.       Those who lend not to pay but to pump in money for businesses at cost of bank or because of many other factors or for evergreening. (here after referred to N)

b)      New customers – which includes small, micro and medium industries  who need credit at lower rates for successfully running business. It also includes customers who will be able to generate cash when money is available at lower rates. (assuming the banks charge lower rate).

If the money gets routed to the Old customers who Sl.No 3 or N , then the whole exercise will go void. 

How to know whether banks are lending for Old Customers Sl. No 3 types or N ( intentionally careless or lending with intent of not paying )?

The current debt equity level and its variations can be analyzed to understand it. (provided company don’t collide with auditing and rating companies in rigging all the processes). If it gets to these customers, then the purpose gets defeated.

If you are further interested you may explore web on 

- Reverse mirror swap

-securitization of swap