Currency swap is a liquidity management tool that central banks use to control volatility in the currency market. It injects dollar liquidity with a repurchase agreement in the interbank market by buying domestic currency when inflation rises and the currency weakens.
The swap auction can be performed in reverse also if there is a shortage of liquidity in the system. The central bank then buys dollars on the market and releases an equivalent amount in national currency.
Why is this desirable now?
The currency swap functions as both a monetary policy tool to reduce local currency liquidity and control inflation while maintaining currency stability.
When the central bank sells dollars, it sucks up an equivalent amount of local currency, thereby reducing liquidity in the system. Last Tuesday, the RBI held a $5.13 billion dollar-to-rupee swap auction as part of its liquidity management initiative, resulting in an injection of dollars and a sucking of the financial system rupee.
“The key to effective liquidity management is ‘timing’ and a nuanced, nimble approach that reacts quickly to how liquidity tilts,” the RBI said in the policy review in early February.
Swap agreements allow the central bank to sell dollars to banks and buy them back after a specified period. Under current circumstances, currency swaps seem desirable as they will reduce domestic inflationary pressures and strengthen the rupee. Based on the current market conditions, it is likely that the RBI will hold more such auctions if the Rupee is hit by a sharp drop in the coming days.
The intervention to halt the rupiah’s fall is consistent with the reversal of ultra-loose monetary policy, which many central banks have undertaken in recent months.