The Reserve Bank of India’s $5 billion tool for liquidity creation is likely to result in faster transmission of interest rates in the banking system and improve liquidity in the banking system at a time when banks are hesitant to pass on rate cut benefits to customers and liquidity is still in deficit mode.
On Wednesday, the RBI decided to inject rupee liquidity for three years through long-term foreign exchange Buy/Sell swap. Under this, the RBI will buy up to $ 5 billion from the market via auction on March 26, and simultaneously sell it back to the same counterparties effective March 2022. Whatever amount of dollars get mopped up via these operations will reflect in the RBI’s foreign exchange reserves for the tenor of the swap while also reflecting in RBI’s forward liabilities. Meanwhile, system gets rupee equivalent liquidity for the same amount and for same duration.
“The RBI move could be aimed at faster rate transmission and boost liquidity in the system. Though the RBI slashed the Repo rate recently, banks are yet to pass on the rate cut benefits. The liquidity deficit in the system has improved but there’s still a derficit of over Rs 30,000 crore,” said an official of a nationalised bank. State Bank of India had recently decided to link savings bank deposits and short-term loans to an external benchmark — the Repo rate — to speed up rate transmission, but others are yet to follow suit.
Liquidity injection may put downward pressure on rates
The RBI’s move to inject liquidity by swapping billion with rupees is aimed at improving the interest rate transmission in the economy. Injection of liquidity is likely to put downward pressure on interest rates in the economy, while at the same time preventing any sharp appreciation of the domestic currency on the back of increased foreign fund inflows. The RBI in last monetary policy review slashed its key short-term lending rate – repo rate – by 25 basis points but commercial banks have so far not reduced lending rates. Through discussions with banks and policy actions, the RBI is indicating the need for a lower interest rate regime.
While the primary objective of using auction based foreign exchange swap is to infuse the rupee liquidity through an alternate channel, there could be other collateral benefits at the same time. The decline in forward premia (especially at the longer tenor) will lower dollar hedging cost for importers. “This also juxtaposes well with the recent relaxation in ECB limits, especially for state owned oil companies, which have unhedged dollar exposures, and can now consider prudential hedging operations. The announcement effect of lower swap rates could persist till the date of the auction — March 26, 2019 — and potentially incentivise few banks to garner FCNR deposits. However, given the tight schedule, it could be somewhat operationally challenging for banks to raise significant quantum via this window (as we saw in the special concessional FCNR window provided by the RBI in the aftermath of Taper Tantrum in September 2013 when banks were able to raise $ 27 bn in a span of 3 months),” said Shubhada Rao, Chief Economist, YES Bank.
Suyash Choudhary, Head – Fixed Income, IDFC AMC, said, “from a more medium term perspective, this may also imply that the RBI is stepping up efforts for transmission. If the RBI has indeed stepped up efforts in this direction, it is very consistent with our expectations from the new Governor. We had outlined in a recent note our assessment that monetary policy has turned more emphatic under Shaktikanta Das and that it was possible to envisage the central bank turning even more proactive on liquidity.”
Given the novelty of the tool and the unexpected announcement, market interpretation of this is still fluid. The first movers are a fall in USD/INR forward premium as well as a reasonable rally in front end corporate bonds. “A lower hedge cost should incrementally incentivize offshore flow into Indian ‘carry’ assets (corporate bonds chiefly),” he said.
Once the tool is introduced, it is quite likely that the RBI follows this up with further such auctions. If so, then cost of hedge may remain better anchored for the longer term thus making rupee assets that much more attractive. The new tool may also implys that fewer open market operations (OMOs) by the RBI, he said.
RBI move has come at a time when systemic liquidity deficit has narrowed from Rs 58,500 crore (end February) to Rs 31,200 crore currently. While liquidity deficit is fairly comfortable as of now, there could be significant tightness in coming weeks on account of durable and frictional factors.