MC Explainer: How the RBI’s USD/INR swap auction may ease liquidity crunch

Reserve Bank of India

The banking system liquidity is expected to get some relief in the coming days thanks to the Reserve Bank of India’s (RBI) $10 billion USD/INR Buy/Sell swap auction coupled with government’s month-end spending towards salaries and pensions.

Additionally, the daily variable rate repo auctions and open market operations (OMO) sales of government securities may also help moderate liquidity deficit, said economists.

“This (swap auction) is likely to infuse close to Rs 85,000 crore -88,000 crores of liquidity in the system. Together with the daily VRR auctions and OMO sales, the liquidity situation should see a sizeable improvement in the coming days,” said Aditi Gupta, Economist at Bank of Baroda.

The central bank will conduct USD/INR Buy/Sell swap auction for a tenor of 3 years on February 28. This move will inject rupee liquidity for longer duration in the banking system.

This will be the second swap auction by the central bank within a month, after it infused $5.1 billion through a six-month swap on January 31.

The central bank's USD/INR Buy/Sell swap auction for a longer tenure provides durable liquidity to the banking system, unlike that provided through daily VRR auctions.

This helps to release the liquidity stress and keep overnight rates close to the repo rate.

Radhika Rao, Senior Economist at DBS Group research said partially hedged External Commercial Borrowings (ECBs) and fresh issuance of ECBs are expected to tap into this auction.

Why liquidity is under stress

Liquidity in the banking system has been under stress since November last year, due to tax outflows, heavy selling by foreign portfolio investors in Indian equities and the consequent intervention by the RBI in the forex market to sell dollars, and lower-than-anticipated government spending.

To support the system the RBI has since late 2024, infused around Rs 3 lakh crore worth of durable liquidity, tapping a combination of VRR auctions, swaps, and open market operations.

Even after this, the liquidity in the banking system remained in deficit of around Rs 1.96 lakh crore as on February 26, according to RBI data.

Aditi Gupta from Bank of Baroda said that more measures might be needed as we move closer to the end of the financial year.

This is because in March every year there is heavy outflow from the banking system in terms of advance tax outflows and GST outflows. To top it, the Indian equities haven't seen comfort from FIIs yet as their selling in the market remains elevated. In addition, this time around, the foreign exchange (FX) intervention by the RBI is also playing a huge role in absorbing liquidity.

Usually during March, liquidity deficit widens and overnight rates shoot up very high, prompting liquidity infusion measures by the central bank.

Impact on Indian rupee

Economists are of the view that the swap auction is unlikely to have much impact on the Indian rupee due to a steady dollar index, but it will shore up India’s foreign exchange reserves.

Kanika Pasricha, Chief Economic Advisor at Union Bank of India said direct impact may be seen on forward premia. “Indirect impact may be muted in our view as the RBI is reversing a small proportion of the significant spot sale of dollars implemented in recent months,” Pasricha added.