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Picture Courtesy: INDIAN EXPRESS

Context:

The Reserve Bank of India (RBI) is conducting its largest-ever $10 billion dollar-rupee buy-sell swap auction to address a severe liquidity crunch in the banking system, stabilize the rupee, and maintain foreign exchange reserves.

Why Was the Swap Initiated?

Liquidity Crisis:

India’s banking system faced its worst liquidity deficit in over a decade in January 2025, peaking at Rs 3.15 lakh crore on January 23—the lowest level in nearly 15 years.
Factors included tax outflows, GST payments, and RBI’s dollar sales to stabilize the rupee, which drained equivalent rupee liquidity from the system.

Rupee Volatility:

The rupee depreciated 3.3% against the dollar between October 2024 and February 2025, hitting 86.86/USD on February 25, 2025.
Foreign investors withdrew $31 billion from Indian equity markets since December 2024, exacerbating forex outflows.

Forex Reserve Management:

RBI’s net forward dollar sales surged to $67.93 billion by December 31, 2024, as it intensified efforts to stabilize the rupee.
The swap aims to replenish dollar reserves while injecting rupee liquidity.

How the Swap Works?

Mechanism:

First Leg (Buy): Banks sell US dollars to the RBI at the Financial Benchmarks India Private Ltd (FBIL) Reference Rate on the auction date. The RBI credits the equivalent rupee amount to the banks' accounts and receives the dollars in its nostro account. This leg injects rupee liquidity into the banking system.

A nostro account refers to a bank account held in a foreign country by a domestic bank, denominated in the currency of the overseas country.

Second Leg (Sell): At the end of the swap period (in this case, 3 years), banks repurchase the US dollars from the RBI by returning the rupee funds they initially received, along with a predetermined swap premium. This reverses the initial liquidity injection, but over a longer timeframe.

Impact

The swap injects Rs 870 billion into the banking system by March 4, 2025, providing sustained liquidity compared to short-term interventions. It reduces pressure on short-term borrowing rates and supports credit flow .

Benefits of the Swap

Liquidity Injection: Addresses the Rs 1.7 lakh crore liquidity deficit as of February 20, 2025. Banks gain predictable cash flows for forex management and liquidity planning.

Rupee Stabilization: Mitigates volatility caused by foreign fund outflows, promoting investor confidence.

Forex Reserve Efficiency: Enhances RBI’s dollar reserves without relying solely on open-market dollar sales .

Potential challenges and considerations

Large-scale swaps can have implications for the RBI's foreign exchange reserves management.

Effectiveness of the swap can be influenced by global market conditions, capital flows, and interest rate differentials.

Market response to the swap auction is not guaranteed and could lead to unintended currency speculation if not strategically executed.

Swaps provide temporary relief, but structural reforms in the financial system might be necessary to address the root causes of liquidity issues for a durable solution.

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Source:

INDIAN EXPRESS

PRACTICE QUESTION

Q.Consider the following statements regarding Buy-Sell Swaps conducted by the Reserve Bank of India (RBI):

In a buy-sell swap, the RBI simultaneously buys a security and agrees to sell it back at a predetermined future date and price.
Buy-sell swaps are used by the RBI as a tool to inject short-term liquidity into the banking system.
The interest rate implicitly charged in a buy-sell swap is linked to the prevailing reverse repo rate.
Commercial banks are the primary participants in buy-sell swaps conducted by the RBI.

How many of the above statements are correct?

A) Only one

B) Only two

C) Only three

D) All four

Answer: C

Explanation:

Statement 1 is correct: This is the fundamental definition of a buy-sell swap. The RBI engages in a simultaneous transaction of buying a security with a commitment to sell it back at a future date and price. This is essentially a short-term loan of funds against securities.

Statement 2 is correct: Buy-sell swaps are indeed a key instrument for short-term liquidity management by the RBI. They are used to inject liquidity into the market for a specific period, typically to address temporary mismatches in liquidity.

Statement 3 is incorrect: The interest rate in a buy-sell swap is not typically linked to the reverse repo rate. Instead, it is more closely aligned with the repo rate. In a buy-sell swap, the RBI is injecting liquidity, similar to a repo operation where banks borrow from the RBI. The cost of borrowing in both cases is related to the repo rate. Reverse repo is when banks park funds with the RBI.

Statement 4 is correct: Commercial banks are the main participants in buy-sell swaps with the RBI. These banks utilize this facility to manage their short-term funding needs and liquidity positions.