Do we see any trade in USDINR FX Swaps ?

In my earlier post, I had promised to cover more on forwards.

In the earlier post on Jan 23, 2023, I had written

"A quick look at the pattern of outstanding RBI forward book shows that in the last 2 years, RBI is seen paying forwards in the last quarter of the FY. In 2021, RBI's forward book swelled from o/s longs of $ 47.38 bn in Jan 2021 to $ 72.75 bn in March 2021. In 2022, a similar pattern was observed where the book swelled from $ 50bn in Jan to $ 66 bn in March 2022."

That prompted the question around the cause of such paying activity. A market veteran guided me to look at RBIs behavior from a balance sheet and capital management perspective and it now makes sense.

So what happens when RBI intervenes in spot market:

When RBI buys foreign exchange, the Net Foreign Assets rise on the RBI's Balance Sheet.

In lieu of FX purchases, RBI releases INR liquidity in the banking system which the banks deposit as reserves. So the size of the RBIs Balance sheet increases (both assets and liabilities).

The motivation behind keeping the Forward book elevated could be explained through the impact on the size of the balance sheet and the consequent capital requirement. So say, if RBI swaps out the Fx Reserves to the tune of USD 20 bn, then 160k crore worth of reserves do not reflect in the balance sheet. The FX swap that reflects as an off balance sheet item consumes a tiny fraction of capital. According to RBI, the Credit exposure for swaps less than 1Y is calculated at Credit Conversion Factor of 2% + positive MTM.

Why doesn't the RBI swap the entire Fx Reserves then ?

The straight answer to that would be dislocation in the fx swaps market. The second aspect is around the management of money supply.

Money supply = Money Multiplier* Reserve money

Reserve money is Currency with public + Cash Reserves with banks + Balances of bank held with the Central Bank. The sources of Reserve money are primarily Net Foreign Assets (NFA) + Net Domestic Assets (NDA). The RBI controls the money supply through changes in NDA + NFA and hence the rational for partially swapping out Fx swaps.

As on 31st Mar 2022, size of the RBIs balance sheet stood at INR 62 trn.

The above explanation helps in understanding RBIs intervention in forwards in the last quarter of the FY.

RBI has been paying forwards since December 2022 when 1Y had dropped to lows of 1.60% ( where we paid forwards at 1.65% and took profits on 40% of our position at 2.05% on Dec 15 and at 2.15% on Dec 23 we squared the balance position)

Now let's look at the market expectations of future interest rates. The implied Fed terminal rate is hovering between 4.90% - 4.95% and then by December 2023 the implied interest rate is 4.45%. On the domestic front, the implied market pricing is for a 25 bps hike in repo rate to 6.50% and then a 25 - 50 bps cut in the second half of the year, taking the year end lower bound rate to 6% - 6.25% (avg 6.1250%). The Dec 23 fwd pricing is at 2.37% whereas back of the hand calculation suggests the differential at 1.675% by end of year.

The above is a pretty superficial way of assessing where should forwards be trading but it does put things in perspective.

The market pricing of implied rate will depend not only on interest rate differential but also depend on the average rates over the life of the swap and the liquidity position to determine the operative rate for liquidity - MSF (deficit liquidity) / Repo / SDF (surplus liquidity).

The current levels, therefore look stretched on the upside. Also 2.40% - 2.50% is a resistance zone where it makes sense to receive for a 30 bps move with a 15 bps stop loss.

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