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Reserve Bank of India moves to ease liquidity squeeze

Increased overseas interest in Indian corporate bonds could be a ripple effect of the Reserve Bank of India’s (RBI) move to use foreign-exchange swaps for easing a liquidity deficit at the country’s banks.

Ahead of forthcoming national elections, the RBI announced that it will hold a US$5 billion FX swap auction for a three-year tenor on March 26. The plan comes as India prepares to spend an estimated 500 billion rupees ($7.2 billion) on a six-week-long campaign starting next month. That, along with a seasonal shortage before the fiscal year-end, is putting a strain on banking liquidity.

The RBI’s plan to swap rupees for dollars with domestic banks is regarded by analysts as helping to achieve its twin objectives of pushing interest rates down while also preventing a sharp appreciation in the rupee (INR).

The RBI cut its key policy rate last month but has struggled to persuade India’s banks to reduce lending rates due to tight cash conditions and high deposit rates. India’s economic growth has fallen to its lowest level in five quarters, just as prime minister Narendra Modi begins campaigning for second term in elections set to be held in April and May.

The central bank’s move could increase fund flows to credit-starved shadow banks which accounted for a third of new loans until last September, when debt defaults by an infrastructure lender hit the sector, bankers and analysts said.

Corporate bond boost

Indian sovereign bonds fell on speculation that the measure reduces the need for the central bank to buy debt via open-market operations, removing a key support for the market. The rupee weakened as some analysts saw the decision as a signal that the RBI isn’t comfortable with the currency’s recent gains.

However, the planned liquidity infusion boosted some financial stocks. “It addresses the liquidity tightness in the financial system and will help revive credit,” Prakash Pandey, head of research at Delhi-based Fairwealth Securities told Bloomberg.

Reports suggest that it is also likely to boost overseas interest in Indian corporate bonds by lowering hedging costs.

“A lower hedge cost should incrementally incentivise offshore flow into Indian ‘carry’ assets, chiefly corporate bonds,” said Suyash Choudhary, head of fixed income at IDFC Asset Management. It also further enhances the appeal of two to five-year AAA Indian corporate bonds on the margin, he added.

While the RBI has been an active participant in the dollar/rupee swap market this is reportedly the first time the central bank has announced an auction. The swap will be a simple buy/sell trade in which banks can place bids to sell their excess dollars to the RBI in and simultaneously agree to buy the same amount at the end of the swap period.

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