As market stabilisation scheme has a limit, RBI had to come up with other methods to drain liquidity due to its forex purchases.
When RBI buys dollars from the open market, it adds rupees into the system. It has an option to delay this creation of liquidity by doing a “sell/buy swap”.
Under this swap, RBI sells dollars along with an agreement to buy them back at a specified price in the future. It does it on the same day when it buys dollars from the market. Thus the liquidity added into system is “sterilized” as it sells dollars and absorbs back the supply of rupees. But this sterlisation is “temporary” in nature. This is because the addition of liquidity is just “delayed or postponed” as RBI has also entered into a forward contract to buy back those dollars.
Central banks like those of South Africa and Australia have been using such swaps to postpone liquidity creation due to foreign exchange inflows.
When rupee has appreciated by around 9-11% per cent since January 2007, RBI decided to experiment with sell/buy swaps in June 2007 as a tool to drain liquidity. The working group proposed sell/buy swaps for a short tenor as longer tenors could prompt banks buying dollars under the swap to lend it for commercial purposes. This would help their clients meet their borrowing needs. This could also force RBI to again buy those dollars and execute successive buy/sell swaps on the “same amount of dollars”.
For RBI, the cost of such swaps is the premium it pays on forward contracts and the earnings on the foreign exchange reserves that it has to sacrifice.