Are the dollar swaps putting pressure on the Indian Rupee?
During the last week, the rupee rapidly weakened against the dollar and went as low as 70.56/$. While oil prices were one of the reasons for the rupee slide, there was another more immediate reason for this rupee fall. It was the dollar swap auctions that set the tone for the weakening of the rupee. Let us see how it worked!
Second tranche of swaps
How exactly does the dollar swap work? The RBI purchases dollars from the banks in exchange for rupees. The only difference is that it is a back-to-back transaction where the RBI commits to sell back the dollar to the banks at the end of 3 years. Future dollars will obviously be sold back at a premium as the dollar has consistently appreciated against the rupee. In the first tranche of dollar swap auctions, the premium to the spot was Rs.7.76 but in the second round the premium was a whopping Rs.8.38. That literally translates into an annual rupee weakening of minimum 4.1%. That is also the yield that the banks will earn from their dollar deposits with the RBI. Most dealers in the market have expressed surprise at the sharp increase in the premium. Also, unlike the first tranche, where the allotment was made to 89 applicants, the second tranche was only allotted to 5 applicants. That has made the entire dollar auctions extremely vulnerable to the pricing efforts of a single player or just a handful of players.
Signal on forward premiums
The dollar swap auctions can be seen as a proxy for the forward premiums. You typically pay a premium for forward dollars as the hard currency normally appreciates over time. That can be seen as a proxy for the dollar auction premiums. When the premium of the auction is hiked from Rs.7.76 to Rs.8.38 in just one month, the market interprets it as a signal of a weak rupee. That was explained by a surge in the forward premiums on the US dollar and most market analysts are now expecting a surge of nearly 25% in the forward premiums. The sharp rise in forward premiums in turn is making the rupee weaker as it is factoring in a stronger dollar in its future projections.
What it means for markets?
Higher premiums on dollar swaps will be interpreted by the market as the RBI giving out a deliberate signal on rupee weakness. Firstly, it could mean that the interest rates in India will remain more dovish compared to other countries and that is good for market sentiment as a whole. But that will also mean that the bond yields could be lower on Indian bonds and that the rupee could weaken consistently. That is not great news for FPIs looking to invest in Indian debt paper. Higher dollar auction premiums could be seen as a negative signal for Indian bonds and that is already visible in FPI activity. Time to watch out!
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