What’s the Point?

The Reserve Bank of India (RBI) announced on February 21, 2025 that in order to meet the durable liquidity needs of the system, it has decided to inject Rupee liquidity for longer duration through long-term US Dollar / Indian Rupee (USD/INR) Buy/Sell swap of US$10 billion for a tenor of 3 years starting from February 25, 2025. As per the operational guidelines mentioned in the Press Release, a bank shall sell US Dollars to the RBI, and simultaneously agree to buy the same amount of US Dollars at the end of the swap period. This will be the RBI’s second swap auction of 2025, following the one held on January 31, 2025 to the tune of US$5 billion with a tenor of 6 months. Such measures for easing liquidity conditions have come at a time when RBI has already carried out rate cut of 25 basis points (bps) to 6.25% in the Monetary Policy Committee February 2025, and has been injecting liquidity by carrying out to conduct Variable Rate Repo (VRR) auctions on all working days in Mumbai since January 15, 2025.

A Perspective on Evolving Liquidity Conditions in India

India’s liquidity conditions have remained tight for a while, with net Liquidity Adjustment Facility (LAF) deficit touching a peak level of ₹3.1 lakh crore on January 25, 2025. Since the start of the daily VRR auctions in January 2025, liquidity conditions have started to show some signs of easing (Please refer to the Green box in Chart 1). This has led to a steepening of the Yield Curve, with 3-month G-Sec falling more than the 10-year G-Sec – 20 bps vs 4 bps between December 31, 2024 and February 24, 2025.

Source: Bloomberg, Centre for Monitoring Indian Economy (CMIE), *Current: February 24, 2025

What is a Currency Swap?

Theoretically, a currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency.

Some Specifics on the USD/INR Swap: The swap announced by RBI is in the nature of a simple buy/sell foreign exchange swap from RBI’s side. In the first leg of the transaction, banks will sell US Dollars to RBI at Financial Benchmarks India Private Limited (FBIL) Reference Rate of the auction date. The settlement of the first leg of the swap will take place on spot basis from the date of transaction, and RBI will credit the Rupee funds to the current account of the successful bidder and the bidder needs to deliver US Dollars into the RBI’s Nostro account – RBI’s bank account in a foreign bank’s branch denominated in a foreign currency. In the reverse leg of the swap transaction, the Rupee funds will have to be returned to RBI along with the swap premium to get the US Dollars back.

Why is RBI conducting a USD/INR Swap?

Over the past 1 year, RBI had been actively selling USD for maintaining the stability of the INR, as evident from the table below, which had partly supported the INR and led to tighter liquidity conditions. Since the outcome of the US Presidential elections, US treasury yields have risen by 82 bps – from 3.62% in 16-Sep-24 to 4.44% in 24-Feb-25. Hence, RBI could have decreased the rate of FX sales after a prolonged period of narrow range trading, leading to a steeper depreciation of the INR in the recent past – falling 3% between 01-Nov-24 and 21-Feb-25.

Now, since RBI wants to reduce the average net LAF deficit levels, it plans to use the USD/INR swap as a tool, in addition to the daily VRR, to actively purchase USD, and supply INR in order to inject higher liquidity into the system.

Table 1: FX Operations in Onshore / Offshore Over-The-Counter (OTC) Segment

Source: RBI Bulletin (February 2025 Edition)

Conclusion

Global economies have been witnessing a slower pace of disinflation, lingering geopolitical tensions and policy uncertainties. India’s high frequency indicators have been sending mixed signals with rural demand continuing to improve and urban demand remaining subdued. Despite that, RBI expects a recovery in private consumption should help achieve GDP growth of 6.4% in FY25 (First Advanced Estimates as per MoSPI). Indian Fixed Income Markets could remain favourable because of the following paths picked by RBI and the Government:

Government’s prudent fiscal consolidation path to the Budgeted Estimate of 4.9% for FY25 and supportive demand-supply dynamics keeping G-Sec yields under check
Softening inflation from its elevated level of 6.21% in October 2024 to 4.31% in January 2025, mainly led by a moderation in prices of key food items
RBI’s liquidity-boosting measure of cutting Cash Reserve Ratio by 50 bps – from 4.5% to 4% in December 2024, and cutting Repo Rate by 25 bps – from 6.5% to 6.25% in February 2025

Falling inflation and potential further cuts to the policy rate could lead to yields to trade with a downward bias. Thus, in view of convergence of elevated short-term rates, better corporate bonds spreads (over G-Sec), expectations of more rate cuts and improved liquidity, investors could consider investing in medium duration (Medium duration funds have Macaulay duration of 3-4 years) categories in line with individual risk appetite, and funds investing in corporate bonds. Further, investors with a relatively longer investment horizon, could increase allocation to longer duration funds in line with individual risk appetite.

Sources: RBI, Bloomberg, CMIE, MoSPI and other publicly available information

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