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Forex Swap

Why is it in News?

RBI, for the 1st time, has resorted to forex swap mechanism to adjust the liquidity in the market.

What is Foreign Exchange (forex) Swap?

  • Under this mechanism, RBI will buy $ 5 billion from the banks in lieu of rupees and after 3 years banks will have to again buy that $ 5 billion from the RBI.
  • Example- Say RBI buys $ 1 billion from Bank X, then after 3 years Bank X will have to buy $ 1 Billion from RBI.

But why does RBI want to pump Liquidity in the System?

  • Whenever Lok sabha electios are arriving, the demand for money increases which may lead to liquidity crunch in the market.
  • Various corporates will start paying Advance Tax in this fiscal year which is another factor that will demand liquidity in the economy.
  • Due to the recent IL&FS crisis, there is negative sentiment in the market; by forex swap, RBI wants to make the money easily available to businessman and corporates.
  • Once RBI buys the dollar to the tune of $5 billion, it will lead to sudden boost in the forex reserves of RBI which can have positive impact in the exchange market.
  • In recent times, Indian economy has seen the surge in Foreign Portfolio Investments (FIIs) which has led to appreciation of the currency, so by buying dollars, RBI wants to counter the appreciation of currency.

What happens when Currency Appreciates?

  • The moment currency appreciates, the exports will become costlier and this will have a direct impact on our Current Account Deficit & Forex reserves.
  • Thumb Rule- Depreciated currency favours Exporters and Appreciated currency deters exporters.

Why did RBI not resort to tools like Open Market Operations & Repo Rate Reduction to adjust the Liquidity?

  • RBI has already used the tool of Repo Rate Reduction but it has not led to significant monetary transmissions.
  • So far as Open Market Operations (OMO) is concerned, RBI has pumped Rs. 2.8 lakh crore through OMO. Therefore, RBI has already exhausted its tools available in the kitty and has now resorted to Forex swap.

Will this move have any Negative Impact on the Economy?

Yes. Once the Government pumps liquidity in the system, it means money is easily available to the people i.e. the demand for the items will increase, leading to inflation.

Some related Terminology:

Open Market Operation (OMO)

It is a tool of RBI, by which it adjusts the liquidity in the system through the purchase & sale of government securities.

Repo Rate

It is also called as the ‘Policy Rate’, which is the rate levied upon the commercial banks when they take money from RBI for a short duration of time. If RBI takes the loans from the banks the rate at which it gets is called as the ‘Reverse Repo Rate’. Usually Reverse Repo is at 1% lower than the Repo Rate.

Source: TH, Financial Express