Since the beginning of 2019 till last month, the Reserve Bank of India (RBI) has already cut the repo rates twice by 25 basis points (0.25%) each time. However, both of these attempts have not resulted into much increase in liquidity in the market.

In response to the 50 basis points (0.50%) cuts by the RBI, the State Bank of India, India’s largest bank, has cut its lending rate by only 10 basis points (0.10%). As expected, by the experts, there was a third cut in the repo rates again in June, thus taking the repo rate to 5.75%, which is the lowest ever in the 10 year period. The worrying part is that it is still highly unlikely that the banks will pass on this decrease in the rates to the borrowers.

Let’s try to understand why the repo rate cut is not proving to be effective in inducing liquidity in the market. Most banks have maxed out on their loan to deposit ratio. That means that banks are unable to lend more without an equivalent increase in their deposits. In order to decrease the lending rates without impacting their profitability, banks will also need to lower the term deposit rates. However, the banks are not in a position to do that without impacting the deposit amounts. At the same time, the RBI also can’t overly rely on the Open Market Operations (OMO) as it will further bring down the 10 year yield (returns on government bonds).

With the recent data of declining GDP released, and the decline in domestic consumption (especially the auto and FMCG sectors), the government needs any help that it can get in increasing the GDPgrowth rate. The next two quarters are not going to be of much help from businesses as this is when most of the write-offs happen and are famously called the ‘Kitchen Sink Quarters’. Hence, inducing liquidity in the market becomes critical at this junction to boost the economic activity.

What happened when all regular ways of monetary policy fail to achieve the desired result?

That is when the RBI decided to tread the uncharted territory. They offered 5 Billion US Dollars worth of currency swaps for the purpose of infusing liquidity for the first time in the history of India on March 26, 2019, and then again in April. Thus, totaling total swaps of 10 Billion US dollars.

The swaps introduced by the RBI are of three-year tenure. In simple terms, the government offered to buy US Dollars with Rupees from the market with the exchange rate as on that day with an option to buy the rupees back at the same rate after a three-year period. The offer was very well received by the market and was heavily subscribed with bids received worth more than 18 Billion USD.

The RBI, in return, will receive a kind of fee, called spread, for this transaction. The spread was Rs. 7.76 for the first swap and Rs. 8.38 for the second swap. Let us understand it with some calculations. The exchange rate during the March swap was Rs. 68.86. This means the RBI accepted dollars at the exchange rate of Rs. 68.86 and gave rupees in exchange. The traders have the options to sell back the rupees they bought after three years at the same exchange rate, plus the spread, i.e. Rs 68.86 + Rs. 7.76 = Rs. 76.62. This spread also takes into account the incremental interest over the three-year period, which amounts to about an annualized rate of 3.56%.

Between April 23,when the second currency swap took place, and now, we have observed varied reactions from economists and market itself. The US dollar to Rupee forward premiums crashed right after the announcement of this swap. Such moves also have the potential to weaken the Rupee in the upcoming days because of decrease in forward rates. The swap was not spread across a longer duration, causing huge movements of currency. While a lot of economists and market guru have lauded this innovative move by the government, some others have raised concerns over the adverse effects. The same move was also questioned during the recently held second bi-monthly monetary policy conference. In the conference, there were also some questions directed at RBI Governor Shaktikanta Das regarding whether the swaps will become a regular feature of the monetary policy moves. The RBI Governor did not confirm this and agreed that this decision will be extended based on ‘Evolving situations’. However, the RBI did admit that ‘For temporary period the hedging rates were sort of impacted differently during the two auctions.’

The US Dollar to Rupee forward premiums is crashed right after the announcement of this swap. Such moves also have the potential to weaken the Rupee in the upcoming days because of the decrease in forward rates. However, this is not the most worrying thing about swaps.

This deviation from regular actions around money policy such as adjusting repo rates and open market actions (OPOs) comes with it’s own risks. It can be argued that every financial decision carries a certain risk. However, this one is different from conventional risks in many ways. And the risks are multifold.

First risk is the interest rate risk. If in the three-year period the interest rate on the US Dollars in the international market decreases, the RBI stands to lose money as will still have to pay the dollars at the pre-agreed rates.

That’s not all, RBI is also betting heavily on the falling Rupee interest rates. If the rupee interest rates rise, the buyers will exercise their option of buying back the dollars at the agreed upon rate, thereby inflicting huge losses for the RBI.

Thirdly, we can’t forget the risk of exchange rate fluctuations on both the currencies. This deal bets heavily again on fall in rupee value in the international market vis-à-vis US Dollars. Any deviation in the opposite direction will again end up hurting the RBI.

In any decision based on speculations involving multiple factors, usually only one factor is unknown and all the others are known or fixed. This particular decision is based on multiple factors, which are unknown, and carry huge uncertainty. The effect of any one or more of these factors going in an unexpected manner can put the entire decision in jeopardy. To say that the profitability (or absence of loss of public money) of this deal rests on very shaky grounds will not be an understatement.

On top of all this, the tenure of this deal is again a big problem. As we know that the accuracy of speculations of any uncertain factor is easier on a shorter duration. For example, it is easy to estimate with some accuracy that the shop around the corner will be in business next week, however, the probability of being accurate will decline significantly if we were to guess that the said shop will be in business after 10 years. The longer the duration, higher is the uncertainty. Hence the decision of RBI to bank on falling rupee, rising dollars, falling rupee interest rates and rising dollar interest rates all at once or being net positive over the next three year period is as risky as it gets. That too when faced with so much instability in the new foreign policies in the USA.

All of this would have been OK if it was done with private money. Hedge funds routinely take bold steps to get high returns for their investors. However, we must not forget that RBI is using taxpayers’ money to dabble in such risky bets, which are not even designed to serve the purpose that the RBI is trying to serve. Also, unlike big hedge funds, RBI does not have the required expertise in this area. This is more or less a shifting of risks to a future three years apart in exchange for a short-term boost in the economy now. The million-dollar question is, will RBI stop after the first two swaps or will this become a regular favorite of the monetary policy committee (MCP).

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