The swap window that was open for banks between September and December 2013 attracted USD 34 billion. The effect of the USD 34 billion inflows is an injection of Rs 2100 billion (Rs 210,000 crores) into the banking system. The injection of Rs 2100 billion is primary in nature i.e money was printed by the RBI. The mechanics of the swap transaction are given at the end of the analysis.
The questions to ask are a) Is the injection of Rs 2100 billion into the system inflationary in nature and will the central bank have to worry about sterilizing the money going forward? and b) is the cost benefit analysis of protecting the Indian Rupee (INR) value working out positively?
In normal market conditions an injection of Rs 2100 billion into the system would flood the market with liquidity. However at this point of time, the market is still borrowing from the RBI in the term repo window, MSF (Marginal Standing Facility) window and overnight repo window (borrowing was Rs 476 billion total as of 6th December 2013). The injection of Rs 2100 billion has not really flooded the market with liquidity.
Going forward, if liquidity does turn easy then this huge injection of Rs 2100 billion could pose problems for the RBI as it would lower interest rates at the short end of the yield curve leading to fall in borrowing and lending costs. Lower interest rates at a time of stickily high inflation could add on to inflationary pressures. RBI would have to sterilize liquidity to lower inflation expectations.
What is the cost to the RBI on opening this swap window? The cost is around USD 1.2 billion a year and the benefit actually goes to banks and NRI’s. Banks were able to arbitrage on the 3.5% swap cost and also earn risk free money by providing leverage to NRI’s to invest in FCNR B deposits. The country’s foreign exchange reserves moved up by USD 14 billion on the back of the swap flows and this has added comfort to the INR that is trading at four month highs.
The INR is up 11% from record lows seen in August 2013 but that is largely contributed by the Fed that did not taper its bond purchase program in September. The currency could be up even if the RBI had not opened the swap window. The question here is that what could have happened if the swap window was not opened and would the INR go back to where it came from if the Fed tapers in December or January? The improved foreign exchange reserves give some cushion to the RBI to intervene in case of volatility on Fed tapering.
The cost benefit analysis at this point of time works out in RBIs favour but repercussions down the line could change the ratio.
