Is RBI's forex swapping window actually useful?

As in 2008, the latest effort of the RBI will have a temporary and limited impact on the exchange rate. Eventually the fundamental factors of fiscal and current account deficits will determine its course, notes A Seshan

In a crisp press release on August 28, 2013, the central bank announced the introduction of a forex swap window for oil marketing companies in the public sector.

It said: “On the basis of assessment of current market conditions, Reserve Bank of India has decided to open a forex swap window to meet the entire daily dollar requirements of three public sector oil marketing companies (Indian Oil Corporation, Hindustan Petroleum Corporation Ltd and Bharat Petroluem Corporation Ltd).

"Under the swap facility, Reserve Bank will undertake sell/buy USD-INR forex swaps for fixed tenor with the OMCs through a designated bank.”

There are different types of swaps available in the market.

One gets the impression that the proposal is of the plain vanilla type.

It is the exchange of the principal amount and interest payments on a loan in one currency for a principal amount and interest payments on a comparable loan in another currency.

The exchange rate, interest rate and the duration of the swap are not known.

Generally the exchange rate at the beginning and the end of the transaction is the same.

Ideally, the RBI should not go by the market rate of exchange since it would then be only validating it.

It should be at a level that it considers reasonable.

The objection will be that it will give an idea of the Bank’s view on the normal exchange rate beyond which it will intervene, something that it has denied all along.

So what?

It is good if it brings down the rate from today’s stratospheric levels.

After all, that is the objective of the swap arrangement.

The interest rate could easily be related to the London Interbank Offered Rate.

The problem will arise when it is time for the OMCs to return the dollars.

If the OMCs have export proceeds to that extent, this will not be an issue.

Of the total exports of $300 billion in 2012-13, petroleum accounted for around 20 per cent.

But this was mostly from the private sector, the Reliance refineries accounting for the bulk ($44 billion).

The very fact that the OMCs are in the market with an average daily requirement of about $300-$500 million is indicative of lack of forex inflows from exports.

The question is whether the RBI will be forced to roll over the swap for another period if the exchange rate continues to be unfavourable and the OMCs incur exchange losses by buying forex in the market in addition to what they are already incurring in their under-priced sales of oil products.

Hedging will add to their costs. Further, as long as the dollars are not returned to the RBI they cannot be shown as part of the reserves. It will affect the external vulnerability indicators such as import cover and influence the country rating adversely.

On May 30, 2008, the RBI announced a special market operation for the smooth functioning of financial markets and for overall financial stability.

It was necessitated after reviewing the systemic implications of the liquidity and other related issues that the OMCs faced arising from the unprecedented escalation in international crude oil prices. The operations began from June 5, 2008.

According to the RBI’s Annual Report, under SMO, it conducted open market operation (outright or repo at its discretion) in the secondary market through designated banks in oil bonds held by public sector OMCs in their own accounts subject to an overall ceiling of Rs 1,500 crore or Rs 15 billion (revised upwards from Rs 1,000 crore or Rs 10 billion on June 11, 2008) on any single day, and provided the OMCs equivalent foreign exchange through designated banks at the market exchange rate.

The settlement of the foreign exchange and the government securities legs of the operations were synchronised so that there was no liquidity impact.

The total amount of oil bonds bought by the RBI under SMO totalled Rs 19,325 crore (about $4.5 billion).

The SMO was terminated effective August 8, 2008.

In the current case, the RBI has adopted a different procedure perhaps for three reasons.

In the first place, the above-mentioned ‘dollars-for-oil-bonds’ exchange was criticised on the ground that it violated the Fiscal Responsibility and Budget Management Act in spirit.

The intermediary of a commercial bank was only a fig leaf to cover it up since there cannot be a secondary market without a primary one.

The oil bonds were straightforward IOUs and not loans raised in the primary market.

But the FRBMA has been dead as a dodo since there were other violations of the Act in principle.

Secondly, the OMCs do not have the oil bonds to the extent that they had them in 2008.

Finally, the main reason for the swap is that, whereas the RBI had comfortable forex reserves of $310 billion -- of which $299 billion constituted foreign currency assets -- as on June 30, 2008, to undertake dollar sales it is not in a similar situation now (with foreign currency assets of $250 billion in total reserves of $278 billion).

The swap is only exchanging current troubles for future ones!

As in 2008 the latest effort of the RBI will have a temporary and limited impact on the exchange rate.

Eventually the fundamental factors of fiscal and current account deficits will determine its course.

A Seshan is an economic consultant and a former officer-in-charge in the department of economic analysis and policy at the Reserve Bank of India