What is Foreign Exchange Swaps (Dollar-Rupee Buy/Sell Swaps)?
Historical Background
Key Points
8 points- 1.
Buy/Sell Swap (as in the news): RBI buys dollars from banks (injecting rupees into the system) and simultaneously agrees to sell dollars back to banks on a future date (absorbing rupees). This injects rupee liquidity.
- 2.
Sell/Buy Swap: RBI sells dollars to banks (absorbing rupees) and simultaneously agrees to buy dollars back from banks on a future date (injecting rupees). This absorbs rupee liquidity.
- 3.
Dual Objective: Can be used to manage rupee liquidity in the domestic market and/or to manage foreign exchange reserves and influence the rupee exchange rate.
- 4.
Mechanism: Typically conducted through auctions, where banks bid for the swap premium/discount.
- 5.
Impact on Liquidity: A buy/sell swap (as mentioned) injects rupee liquidity into the system for a specified period, helping to ease tight domestic liquidity conditions.
- 6.
Impact on Forex Reserves: Temporarily increases or decreases RBI's foreign exchange assets, but the net position reverses on maturity of the swap.
- 7.
Flexibility: Offers more flexibility than outright OMOs as it can be tailored for specific tenors and can address both domestic liquidity and external sector dynamics simultaneously.
- 8.
Used to sterilize the impact of capital flows on domestic liquidity without directly impacting the exchange rate in the long term.
Visual Insights
Mechanism of Dollar-Rupee Buy/Sell Swap (Liquidity Injection)
This flowchart illustrates the process of a dollar-rupee buy/sell swap, a tool used by the RBI to inject rupee liquidity into the domestic financial system while managing foreign exchange flows. It shows both the spot and forward legs of the transaction.
- 1.RBI Assesses Need for Rupee Liquidity Injection
- 2.RBI Announces Dollar-Rupee Buy/Sell Swap Auction
- 3.Commercial Banks Bid in the Auction
- 4.Spot Leg: RBI Buys USD from Banks (Injects INR into System)
- 5.Rupee Liquidity in the Domestic Market Increases
- 6.Forward Leg (Simultaneous Agreement): RBI Sells USD Back to Banks on a Future Date (Absorbs INR on Maturity)
- 7.On Maturity Date: Banks Pay INR to RBI to Buy Back USD
- 8.Rupee Liquidity is Absorbed from the System (Temporary Injection Reverses)
Dollar-Rupee Buy/Sell vs. Sell/Buy Swaps
This table differentiates between two types of foreign exchange swaps used by the RBI: buy/sell swaps and sell/buy swaps. Understanding these distinctions is key to comprehending how RBI manages both domestic rupee liquidity and foreign exchange market dynamics.
| Feature | Dollar-Rupee Buy/Sell Swap | Dollar-Rupee Sell/Buy Swap |
|---|---|---|
| Initial Spot Action by RBI | RBI buys USD from banks (injects INR) | RBI sells USD to banks (absorbs INR) |
| Impact on Rupee Liquidity (Initial) | Injects rupee liquidity into the system. | Absorbs rupee liquidity from the system. |
| Forward Action by RBI (on Maturity) | RBI sells USD back to banks (absorbs INR). | RBI buys USD back from banks (injects INR). |
| Net Impact on Rupee Liquidity | Temporary injection of rupee liquidity. | Temporary absorption of rupee liquidity. |
| Impact on RBI's Forex Reserves (Initial) | Increases RBI's forex assets temporarily. | Decreases RBI's forex assets temporarily. |
| Primary Purpose | To ease tight domestic rupee liquidity conditions. | To absorb excess domestic rupee liquidity. |
| Example Scenario | When domestic liquidity is tight and RBI wants to inject funds. | When domestic liquidity is abundant and RBI wants to drain funds. |
Recent Developments
4 developmentsUsed extensively by RBI during periods of dollar scarcity or excess rupee liquidity to manage market conditions.
Significant dollar-rupee buy/sell swaps were conducted during 2019-2020 to inject rupee liquidity and manage foreign exchange flows.
Helps in managing the impact of large capital inflows or outflows on domestic liquidity and the exchange rate.
RBI's proactive use of swaps as a non-disruptive tool to manage both domestic liquidity and exchange rate volatility.