Last month, we wrote about how the RBI is defending the rupee. It was trying hard to prevent the rupee from depreciating against the dollar. But now, a decision from the past could be coming back to haunt it. And in today’s Finshots we give you a simplified version of what might be going on.

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The RBI likes to keep one thing firmly under control — liquidity. Or in simple terms, the amount of money sloshing about the system.

Because if there’s too much money lying with banks, they might be tempted to lend it out quickly. Corporates could borrow and expand their business. People might take loans and spend — buy new cars, take holidays etc. Demand could shoot up. You know what happens as a result of that right? It can push prices higher and we get the dreaded inflation.

Now typically, the RBI resorts to a few tried and tested tricks to rein in this excess money.

For instance, it could raise interest rates. There’s something called the reverse repo rate. Just think of this as the rate at which banks can deposit money with the RBI. So whenever the RBI wants to nudge banks into depositing excess money in its vault, it will increase the reverse repo rate. Or these days, it raises the rates for something called the Standing Deposit Facility which works in a similar manner. The liquidity drops either way.

Or, the RBI could indulge in some Open Market Operations (OMO). They sell government bonds to the banks. Banks part with the money they have and voila, the excess money gets sucked out again.

But in April 2022, the RBI decided to do something else too. It announced a currency swap. It told banks, “We’re going to give you $5 billion from our forex reserves immediately since we have plenty of dollars. You give us rupees in return. In October 2023, we’ll reverse this deal. We’ll give you back the rupees plus a premium at a predetermined rate. And you hand back the dollars.”

Now it’s not often the case that a central bank toys with currency swaps to suck out liquidity. But the RBI was increasingly relying on this tool. And this endeavour removed nearly ₹40,000 crores from the banking system. To be honest, this wasn’t a massive sum of money. There was an excess of over ₹7 lakh crores in the banking system. So it was a drop in the bucket.

So we dug around. Maybe the RBI had another goal too. And some experts believe that it had something to do with the rupee. You see, back then the rupee was going through a bout of depreciation against the US dollar. It was losing its value. But offloading dollars and buying rupees from the banks would give it some support. And it probably worked. Its price rose and it staved off further depreciation.

Also, there’s one more bit. And remember this is just a hypothetical example of how a transaction like this might work. The RBI might look at what the market quoted for a ₹/$ trade. Firstly, there’s the spot market, where an immediate trade would take place. Maybe this indicated that $1 was worth ₹70. Then the eyes turn to the forward market, where say the trade would be settled in a year’s time. And maybe this signalled that $1 would be worth ₹73 in a year. That ₹3 is the forward rate premium.

Putting these two things together, the RBI might say, “Look, we’ll give you $1 dollar in return for ₹70 now. And a year later, when you give us back the $1, we’ll give you ₹73.5.

Why on earth would the RBI offer a premium? Well, maybe the premium is an incentive for the bank. Something to convince them to enter a swap deal with the RBI. (Again, remember this is just hypothetical. The RBI might impose a discount or a premium depending on the many variables it thinks might affect rupee value and liquidity).

So anyway, if you think about it, giving a premium may not seem like a great idea. It kind of shows that the RBI is betting on the rupee’s depreciation. But there’s a flip side to that.

See, this forward market premium is also a reflection of interest rate differentials between two currencies. If the forward premium remains high, it could indicate that interest rates in India are much higher than in the US. And that could lure people into something called a carry trade. Traders might choose to borrow in the currency which is associated with a low interest rate (the dollar). And invest in another currency which gives a higher interest rate (the rupee). Suddenly, the rupee looks attractive, the demand for it rises, and it might actually support its value.

Basically, the RBI could kill two birds with one stone — banking liquidity and rupee depreciation.

Also, this way, no one could accuse the RBI of meddling with the currency. It could just turn around and say, “Hey, we did it for the liquidity. The impact on currency was just a second-order effect.”

So far so good?

Alright then, let’s cut to today.

So on 23rd October, this swap deal comes to an end. That means, the RBI will give back the rupees (along with the agreed-upon premium) to the banks. In return, it’ll expect banks to hand over dollars — $5 billion worth of it.

And here’s the thing. Banks don’t seem to have so many dollars in their accounts. Maybe they expected the RBI to roll over the swap agreement or extend the maturity by a bit. So now they’re scrambling to get their hands on the greenback. They’re trying to buy dollars.

Now you know what that means, don’t you?

A strong demand for dollars could weaken the rupee further. And the forward market behaves in reverse. The premiums fall. People either don’t participate in the carry trade anymore or they try to exit their positions. That’ll mean selling pressure on the rupee. And it could impact the value even further.

So yeah, all this might just negate the strategies the RBI has been employing to defend the rupee value lately. And we’ll just have to wait and see how the RBI plays this now.

Until then…

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