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Posted on 29-Mar-2019 Comments  0

Dollar Swaps

Dollar Swaps could actually hit three birds with one stone

In the last week of March, the RBI introduced the new concept of dollar swap auctions in the Indian money markets. The first issue of dollar swaps attracted buying interest of $16.3 billion against the offer size of $5 billion. That surely means that there could be more such issues in the future. But what are these dollar swaps and how do they really benefit the markets?

How dollar swaps work?

The dollar swap is an interesting scheme wherein the RBI buys dollars from the commercial banks and pays them rupees instead. This dollar swap is a back-to-back deal with 3-year tenure. The banks are aware that they will be able to covert this money back into dollars at the end of 3 years at a cost that is determined in advance. The RBI has set the pricing in such a way that the swap is slightly more attractive than the market yields. For banks it is a good and profitable way to put their dollar inflows to work. There have been substantial dollar inflows coming into India in the form of FPI flows, NRI remittances, FDI flows etc. The RBI can use these dollars to shore up their dollar reserves and at the same time infuse liquidity into the market. At the same time, since the swap entails purchasing the dollar in exchange for rupees, it has the tendency to prevent the rupee from getting too strong. That is likely to work in favor of the exporters who normally tend to benefit from a strong dollar.

Why is liquidity tight?

Liquidity shortfall in the financial markets has been to the tune of nearly Rs.2 trillion as of the end of March when the income tax and GST payouts become due. The RBI has been infusing nearly Rs.40,000 crore each month but that has not been sufficient. With the liquidity already tight in the aftermath of the NBFC crisis late last year, there is the need to use liquidity infusion in a different way. The traditional OMOs have a limitation because last year nearly 75% of the total bonds issued by the government devolved on the RBI. Dollar swaps offer a way out.

Hitting 3 birds with 1 stone

In a way, the dollar swap auction is like the RBI hitting 3 birds with one stone. Here is how it works. Firstly, the issue of liquidity in the market is addressed without too much of bonds devolving on the RBI books. This is also more effective than a rate cut in the current market conditions. Secondly, this move can offer a boost for exporters. When the RBI buys dollars, it makes the dollar stronger vis-à-vis the rupee. This makes exporters more competitive. Lastly, the dollar swaps also bolster the RBI forex reserves. From a high of $430 billion, the reserves have fallen to around $400 billion. That is just about 9 months of imports, which is lower than what BRC nations maintain. The swap can actually achieve more with lesser side effects!


For the third time, BREXIT Deal was rejected and so will BREXIT

For the third time in succession, the proposed BREXIT deal was rejected by the British Parliament. Theresa May counted on a mix of Conservatives, North Irish party and Labor dissidents to help the BREXIT deal sail through. In fact, Theresa May had even committed to resign from the chair if the deal was passed. Despite all the efforts, the anti-BREXIT deal vote was quite decisive. But first, let us look at this BREXIT imbroglio a tad deeper. 

BREXIT deal brouhaha

The BREXIT deal was basically an agreement between the UK and the EU to ensure that Britain’s exit from the EU was orderly rather than chaotic. In fact, the Bank of England has projected that a sudden BREXIT could compress the GDP of Britain by nearly 7% in the short to medium term. That would be a lot of chaos and disruption to handle. As far as the British people are concerned, they have a simple point; we voted to exit the EU, the deal is your problem! When the referendum in 2016 clearly voted for Britain to exit the EU, the belief was that the 3 year time frame would give UK enough time to work out an orderly exit. However, there has been little progress on negotiations in the last 3 years. UK expects unrealistic concessions, which the EU is unwilling to cede. For the people of Britain, BREXIT is a must because the costs in terms of membership of the EU and the refugee costs were just too prohibitive.

What is the way out now?

Broadly, there are 3 options in front of Britain at this point of time. Firstly, Theresa May will have to resign and Britain may call for a fresh elections. The onus will then be on the new government to deal with the BREXIT mandate. Secondly, another option would be to initiate BREXIT and deal with the consequences as they come. UK had taken a similar stand in 1992 when it was forced out of the common currency. But that was a different scenario with lesser global linkages. It may be a blind date for the government. Lastly, UK may want to give a silent burial to the idea of BREXIT and let the status quo continue. This may be against the referendum mandate but then you can argue that the modus operandi would have been too complicated and too painful.

Is the BREXIT idea over?

Without sounding too prophetic, it does look like it may best suit everyone’s interests to give the idea of BREXIT a silent burial for now. UK can have Track-2 negotiations with EU on the costs and the issue of absorbing refugees into its fold. These are not really complicated issues. UK and EU realize that it is in their larger common interest to stay integrated and prevent other nations from benefiting from the stand-off. BREXIT may get a quiet burial, but who will bell the cat?

Loan Benchmarking

It looks like external benchmarking for loans is off the table for now

Back in the December monetary policy announced by the RBI there was special mention of the banks shifting to an external benchmark for pricing loans. This was part of the policy statement and was expected to make a big difference to the way banks priced their loans. The new external benchmarking for loans was to become effective from April 01st but just a few days ahead the government has put off the plan. What exactly was this plan and why is it not taking off for now?

About loan benchmarking

This announcement was made when Dr. Urjit Patel was still the Governor of the RBI. The idea was that when the RBI cut repo rates, the transmission was not taking place as anticipated. This was reducing the efficacy of monetary measures as the cost of borrowings was not coming down. Hence RBI had then announced the intent to move towards external benchmarking of loans to retail borrowers and small businesses, which were of a floating rate variety. The idea was that by linking the price of loans to an external benchmark like the repo rate or the Libor, the transmission of rate cuts will be more seamless. This will also make the monetary policy more effective. However, in the last few months the government and the RBI had received objections from various banks as a result of which, the decision has been taken to study the matter in greater detail before a decision.

All about cost of funds

Currently, Indian banks benchmark their lending rates based on their cost of funds. Some banks look for average cost of funds for most borrowers and incremental cost of funds for select borrowers. Either ways, the rate at which loans are given is benchmarked to the cost of funds. The RBI has suggested that the current practice has the potential to inculcate inefficiencies in the banking system as the bank has no incentive to bring down its cost of funds. Of course, the pressures of competition are quite critical but the market for loans is so wide and disparate that it does not really work like a competitive market. Banks have been unwilling to shift their pricing away from cost of funds. Their contention has been that any pricing divorced from the cost of funding is a recipe for disaster.

What about cost of deposits?

Actually, that is the million dollar question. To have a fully flexible benchmark for lending, you also require a flexible benchmark for pricing the deposits. However, a floating rate deposit is something neither the depositor nor the regulator is willing to accept. In the absence of benchmarking of deposits, the entire concept of loan benchmarking is likely to be one-sided and therefore ineffective. This has been tried in the past also. Eventually, banks gravitate towards the cost of funds!




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