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By B PrasannaIn a move that is reminiscent of the Foreign Currency Non-resident Scheme launched during the taper tantrum of 2013, the Reserve Bank of India has announced an auction for a buy/sell (B/S) swap for a three-year maturity for $5 billion (Rs 35,000 crore).
The Fx and money market participants are engaged in a heated debate as to whether this is merely an addition to RBI’s liquidity or whether it is a move to bring down hedging cost.
Either way, the move has implications.
Firstly, the genesis of the need to announce such a B/S swap was probably the need to find one more tool to inject liquidity.
Just like the current year, projections indicate that the perennial bug bear of liquidity –– the increase in currency in circulation –– will again necessitate the RBI to undertake large scale operations to infuse liquidity in the next financial year as well.
RBI’s OMO purchases however has its own twin limitations of indirectly funding the government borrowing programme and in having an overbearing influence on the sovereign yield curve.
There has been an increase in the domestic assets in the RBI’s balance sheet due to these purchases and there was a need to balance the same by increasing the foreign exchange assets.
These reasons may have been the driving factors behind the announcement.
Secondly, the move will have implications on forward premia and MIFOR curve in India.
While forwards up to one year is directly traded in the market, anything beyond a year is traded through the MIFOR curve, which is a combination of USD IRS and forward premia.
Since RBI will be the receiver of forward premia for three-year maturity under the swap to the extent of $5 billion, it will lead to a fall in FX swap rates.
There will be good receiving interest in MIFOR from traders in anticipation of a fall in rates when RBI receives.
Thirdly, lower forward premia and MIFOR would make it easier for the balance sheets of banks and corporates to raise dollar funds offshore and swap it into cheaper rupee liquidity.
A fall in the landed rupee cost will incentivise them to be incrementally more aggressive in the offshore market for liquidity.
Fourthly, the reduction in forward premia, would incentivise FPI flows into debt instruments especially in corporate bonds, where on a fully-hedged basis, the spreads become more attractive.
This is relevant in the light of the “Voluntary Retention Route” which puts limits to FPIs for sovereign and corporate bonds for a lock-in of three years.
In spot markets, the timing of RBI sterilisation becomes important for spot dollar behaviour.
The announcement of B/S swap route to sterilise dollar liquidity indicates less than aggressive spot intervention.
With moderating trade deficit, subdued inflationary environment and surfeit of capital inflows, RBI is probably implicitly suggesting a higher tolerance for rupee appreciation in the near term.
As far as interest rates are concerned, liquidity infusion should be supportive of the short-end sovereign curve even as the diminishing prospects of OMO purchases will continue to pressure the long end resulting in (bullish) steepening.
Corporate bonds are likely to be the biggest beneficiary due to higher demand from FPIs and lower supply from corporates as they look for alternative source of borrowings in the offshore market.
This could drive the interbank funding costs lower as bank balance sheets use this route to generate cheaper landed cost of funds.
The other big impact could be on the elevated MIFOR-OIS spread which has expanded to record high in recent years, thanks to regulatory prescription mandating 70% compulsory hedging of ECB flow by Indian corporates.
The skewed hedging flow which led to distorted MIFOR curve will get balanced with the new receiver in the market, leading to a compression of this spread for the larger good of real users.
For the economy, this has the potential to create a virtuous cycle where lower cost of funding aided by global liquidity ensures that a rising saving-investment gap in India does not translate into another external funding crisis even as it provides a fillip to investment just as an accommodative monetary policy stance would seek to achieve.
The author is head-global markets group, ICICI Bank.
