RBI deploys dollar swaps as ₹11 lakh cr glut swells

India's central bank, the Reserve Bank of India (RBI), has employed currency swaps to reduce cash held by banks, amid a record surge in excess funds within the financial system. The monetary authority conducted short-term sell-buy foreign-exchange swaps, some of which will expire in October, according to sources familiar with the matter. However, they declined to disclose the exact size of the deal for privacy reasons.

Under these transactions, the RBI sells dollars to banks in exchange for rupees and commits to repurchase the US currency at a later date. This action effectively reduces liquidity from the banking system, as the monetary pool in India has swelled to approximately 11 trillion rupees ($115 billion) following substantial inflows under the RBI's recent capital-raising initiatives.

While the RBI did not comment on the matter, its spokesperson declined to provide further details. In the meantime, the three-month dollar-rupee onshore forward yields have increased by 23 basis points to 3%, while the six-month yields have risen by 15 basis points.

The substantial cash surplus has put downward pressure on banks' funding costs, creating a challenge for the RBI. This situation may potentially exacerbate inflation risks, as cheaper borrowing could stimulate further economic activity. Market participants have been closely monitoring the RBI's stance on tackling this liquidity surplus, with bond and currency traders eagerly anticipating any interventions by the central bank.

Economist Madhavi Arora from Emkay Global Financial Services cautioned that "sell/buy swaps can push the liquidity problem into the future, but not eliminate it." She suggested that the RBI could utilize six-to-12 month swaps to neutralize the large liquidity injection without immediately resorting to domestic bond market instruments.

However, Arora also noted that large auctions could heighten forward premia if the market finds it difficult to absorb the inflows, thereby intensifying hedging costs and potentially escalating the RBI's expenses when rolling over these swaps.