• The RBI’s decision to infuse rupee liquidity through long term foreign exchange swap, a first of its kind in liquidity management policy, is likely to boost investments by foreign portfolio investors under the voluntary retention route (VRR).
• The central bank will conduct dollar-rupee buy/sell swap action of $5 billion for a three-year tenor. Such a swap route has been explored by various emerging market economies as an effective tool to manage liquidity.
• Apart from liquidity infusion, the move will boost the country’s foreign exchange reserves and is likely to support the exchange rate.

Background:

• Through this step it would buy as much as $5 billion from the banks in a swap deal that could inject nearly 35,000 crores into the system. Banks would be required to park dollar funds with RBI with a deal to buy it back from the RBI after three years.
• The auction for this first of its kind US dollar buy/sell swap auction will take place on March 26. The auction cutoff would be based on the premium amount in paisa terms and the auction would be a multiple price-based auction.
• This is the first time the central bank is using a foreign exchange auction to augment banking liquidity after generally using bond purchases for this fiscal.
• RBI also has raised the trade credit limit under the automatic route to $150 million for oil/gas refining and marketing, airline and shipping firms. For others, the limit is set at $50 million or equivalent per import transaction.

Significance:

• The move is seen to lower the dependence on open market operations which have been a significant amount of the overall borrowing. “Higher OMOs can distort the rates curve,”
• The move would boost RBI’s foreign exchange reserves which were at $401.7 billion for the week ended March 1.
• The revised framework has reduced the al linclusive cost (all in cost) for overseas loans to benchmark rate plus 250 basis points from the earlier 350 bps.

Open Market Operation, Foreign exchange swaps (Forex)

• Open Market Operation (OMO) is a transaction on the open financial market, involving fiscal instruments such as governments` securities, or commercial papers, commenced by a central banking authority, with the purpose of regulating the money supply and credit conditions.
• OMO is a direct instrument of monetary policy, because the instrument influences the money supply directly. Forex swaps and other types of foreign exchange operations are also open market operations.
• In a foreign exchange swap, two parties exchange specific amounts of two different currencies and repay the amount of the exchange at a future date, according to a predetermined rule reflecting both interest payments and amortization of the principle.