Reddy Goes Forward To Curb Re Rise

Reserve Bank of India governor Y V Reddy is using all his experience at the central bank to tide over an unusual monetary challenge - to prevent the rupee from rising sharply despite huge dollar inflows… and to do so without infusing extra money into the banking system.

To prevent the rupee from rising, the central bank has been buying dollars in the forex market. This in turn has pushed up money in the banking system, leading to inflationary pressures.

To negate the impact of this dollar-buying on liquidity, the RBI enters into a sell-buy swap.

"In order to postpone the infusion of liquidity, state-owned banks (on behalf of RBI) are buying dollars and entering into a 'sell buy swap' in the forward market. This allows them to buy forward dollars and delay the rupee sale to the date of the settlement of the forward contract," said L Subramanian, chief manager, global markets group, ICICI Bank.

A swap is an exchange of one currency for another at two specified dates. These are forward contracts which have periods of 1 month to 1 year. Such deals do not affect the exchange rate.

For simplicity, assume the dollar is at Rs 100 today. In a sell-buy swap, the RBI will sell one thousand dollars for Rs 1 lakh. Thus Rs 1 lakh is out of the banking system now. At the expiry of the forward sell-buy swap, say in 3 months, this Rs 1 lakh will come back into the system. In this way, the RBI can buy dollars and at the same time ensure that it does not add extra liquidity to the system.

The beauty of the forward contract is that the RBI can postpone the rupee sales further by just rolling over the contract at the time of maturity.

Forex dealers say this is the first time the central bank is doing this in the Reddy reign. "They haven't done this for a long time. But it was more to soothe the forward market. This is the first time they are challenged with such inflows," said a former dealer with a state-owned bank who is familiar with the RBI's forex tactics and is now with a private sector bank.

"This strategy could also work well to the extent that there is no shortage of dollars in the market that would then lead the forward markets into discount", said Mohan Shenoi, head of treasury, Kotak Mahindra Bank, at a round table discussion on managing capital flows organised by the Bombay Chamber on Wednesday.

However in the last couple of days state-owned banks have not been that active as the rupee has weakened on its own due to high oil prices and weaker dollar inflows.

State-owned banks didn't have to step in on Wednesday too as the over 1000 point crash in the stock market led to the rupee falling by the most in two months.

The markets crashed reacting to a late night proposal by the Securities & Exchange Board of India (SEBI) to curb foreign investors buying derivatives linked to local shares.

Dealers expect the rupee's gains to be cut in the next one month following the SEBI proposal. "The rupee recovered some losses on Wednesday but I think in the near term the SEBI move will lead to some dollar buying which could push the rupee towards 40 rupees per $1 or possibly even Rs 40.20 per $1 in a months time," said R N Subramanian, assistant vice president and head forex spot, Axis Bank.