RBI's liquidity mop-up via FX swaps offers a channel of support for rupee

The Reserve Bank of India's (RBI) use of foreign-exchange (FX) swaps to remove excess rupee liquidity is indirectly bolstering the value of the rupee, according to traders. On Thursday, the RBI executed dollar/rupee sell-buy swaps for the second consecutive day, with most operations concentrated in December maturities. The forward premiums soared in response, with the one-year annualized implied rate increasing by almost 30 basis points over two days.

Near-term tenors experienced even more significant moves, with the one-month premium climbing 90 basis points.

By raising the forward premiums, the RBI's swaps increase the cost of betting against the rupee and hedging dollar liabilities. This action may discourage importer demand for forwards while encouraging exporters to sell dollars, providing a modest buffer for the rupee at a time when it has been pressured by a renewed surge in crude oil prices. The surge in crude oil prices is attributed to the most significant wave of attacks on shipping since the six-month-old conflict between the U.S. and Iran.

Analysts at ANZ Bank noted that the RBI likely conducts FX swaps to absorb overseas deposit-driven liquidity. On Thursday, one trader estimated the swaps conducted at around $600 million to $700 million, in addition to $1 billion on Wednesday. Another trader suggested that the RBI had conducted "less than $1 billion" in swaps so far on Thursday.

The shift in hedging costs stems from persisting importer demand for dollar hedges and exporters' reluctance to sell their dollar earnings, leading to persistent flow imbalances in the rupee market. However, hedging costs are just one factor that businesses weigh when deciding to buy or sell dollars forward. Spot rates and expectations for the rupee's future trajectory also play a crucial role.

For exporters, the surge in forward premiums, combined with the rupee's weakness to 95.35 per dollar, provides further motivation to sell dollars forward. Yet, higher forward premiums alone may not be sufficient to entice them back into the market significantly, according to an FX salesperson at a major bank. "While significantly higher forward premiums certainly improve the incentive to sell dollars, unless the oil price trend changes, exporters are likely to remain cautious."