The $34 billion swap arrangement offered by the RBI to banks has resulting in the printing of more than Rs 2,10,000 crore in rupee. Will this boost inflation?

The dollar-rupee swap window that was open for banks between September and November 2013 attracted $34 billion. Since the idea of the swap is to allow banks to borrow in dollars and convert the money into rupees at favourable costs, this has resulted in what could probably be the largest single money printing exercise in India over such a short period of time.

The net effect of the $34 billion inflows is an injection of Rs 2,100 billion (Rs 2,10,000 crore) into the banking system. This injection is primary in nature, i.e money was printed by the Reserve Bank of India (RBI). The mechanics of the swap transaction are given at the end of the analysis. When we say printed, it means the money exists in the books of banks as cash.

The questions to ask are: a) Is the injection of Rs 2,10,000 crore into the system inflationary in nature and will the central bank have to worry about sterilising the money (i.e. locking up the money again by issuing short-term bonds/T-Bill against this cash) going forward? and b) is the cost-benefit analysis of protecting the Indian rupee (INR) value working out positively?

In normal market conditions, an injection of Rs 2,10,000 crore into the system would flood the market with liquidity. However, at this point of time, the market is still borrowing from the RBI in the term repo window, MSF (Marginal Standing Facility) window and overnight repo window (borrowing was just under Rs 60,000 crore as on 9 December 2013). The injection of Rs 2,10,000 crore is thus yet to flood the market with liquidity. The coming 15 December deadline for the payment for advance taxes will also ensure that this money does not let loose a sharp cut in short-term rates.

Going forward, however, if liquidity does turn easy then this huge injection of Rs 2,10,000 crore could pose problems for the RBI as it would lower interest rates at the short end of the yield curve, leading to a fall in borrowing and lending costs. Lower interest rates at a time of sticky, high inflation could add to inflationary pressures. The RBI would have to sterilise liquidity to lower inflation expectations.

What is the cost to the RBI on opening this swap window? The cost is around $1.2 billion a year and the benefit actually goes to banks and non-resident Indians (NRIs) who have lent banks most of this money in the form of dollar deposits. Banks were able to arbitrage on the 3.5 percent swap cost and also earn risk-free money by providing leverage to NRIs to invest in foreign currency non-residents (banks) scheme (or FCNR-B) deposits. In FCNR(B) deposits, normally banks have to bear the exchange rate risks, but with the RBI bankrolling that cover, banks are spared the risks.

The country's foreign exchange reserves moved up by $14 billion on the back of the swap flows and this has added comfort to the INR that is trading at four month highs.

The INR is up 11 percent from record lows seen in August 2013 but that is largely contributed by the US Fed that did not taper its bond purchase programme in September. The currency could be up even if the RBI had not opened the swap window. The question here is what could have happened if the swap window was not opened and would the INR go back to where it came from if the Fed tapers in December or January? The improved foreign exchange reserves give some cushion to the RBI to intervene in case of volatility on Fed tapering.

The cost benefit analysis at this point of time works out in RBI's favour but the repercussions down the line could change the ratio.

How RBI added Rs 2,10,000 crore into the system through FCNR(B) Swap Window

RBI opened a swap window for banks in September 2013, where it allowed banks to sell USD to RBI at a daily published rate and buy back the USD from the RBI anytime after three years and going upto a maximum period of five years. The cost of the swap to the banks was 3.5% per annum.

The swap window of the RBI was specifically for FCNR(B) deposits and overseas borrowings of banks. The swap window closed on 30 November 2013.

The swap window attracted USD 34 billion, which banks sold to the RBI.

The way the swap transaction works is as follows.

Banks sell USD 34 billion to RBI at INR 62

RBI buys USD 34 billion and pays banks Rs 2,10,000 crore (at current exchange rates)

USD 34 billion x INR 62 = Rs 2,10,000 crore. We are assuming that the average rate for purchase of USD by RBI is Rs 62

RBI prints the money to buy USD from banks, and the Rs 2,10,000 crore purchase of USD from banks is a direct injection of money into the banking system. The purchase of USD 34 billion is a direct accretion to the foreign exchange reserves of the RBI.

What happens at the end of five years, assuming the swaps were all for a five-year period?

The RBI will sell USD 34 billion to the banks at the end of five years at INR 73.74

Rs 62 x 3.5 percent, compounded semi-annually for five years = Rs 73.74

Banks will pay Rs 2,50,000 crore to the RBI to buy back USD 34 billion.

Banks will draw down liquidity of an equivalent amount to buy USD 34 billion from RBI. The RBI's dollar reserves will be correspondingly depleted.

Only time will tell if this exercise was worth it, but the risks are clear: the possibility of easy money stoking inflation which could paradoxically bring down short-term rates; and the possibility of having to repay Rs 2,50,000 crore after five years, when we cannot be sure what liquidity conditions will be.

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Arjun Parthasarathy is founder Investors are Idiots.com and INRBONDS.com. Follow him on twitter #investorsidiots