On 26th March, the Reserve Bank of India announced an unconventional action to manage rupee-liquidity in the banking system.
Any policy decision which is not part of the “routine and text-book” activities gets dubbed as “unconventional” by market. RBI has been actively managing rupee liquidity by open market operations by which it buys financial assets and in-return pays rupees for it to ensure r
As part of the swap-deal, RBI would take $5bn from qualifying banks and give back rupees as the first leg of the swap deal. The exchange of dollar would be at reference rate  prevailing on the day of auction and settled on spot basis.
Reference Rate is the spot rate compiled by polling “ selected banks” between 1130 hrs and 1230 hrs and published by FBIL. It is declared everyday excluding weekends and bank holidays. Currency derivatives contracts are settled on the final day on the basis of reference rate
In the second leg, banks would take back those dollars from RBI at a premium which banks would bid for during the auction. So, the banks that bid above the cut-off would qualify for the swap deal
Only Category-1 banks were eligible to bid in this swap deal
However, many analysts felt that buying of dollars from market participants like foreign banks by RBI would create short-supply of dollars in the market, and hence push up rate of USDINR. But, RBI was willingly to buy only $5 bn in the swap deal and hence the banks whose bids were not accepted were just left with all the dollars they raised to exchange for rupees with RBI. RBI received 225 bids worth !16.5 bn, which was 3 times the offer amount making the bid cover ratio as 3.1
After the announcement, the difference between USDINR forward rate and spot rate called the USDINR forward-premium, fell as much as 51 points as market prepa
Why were banks so much interested in auction?
As banks were hoping to get a swap rate/forward rate lower than the prevailing rate, they bid aggressively. They could exchange their dollars for rupees for, say Rs 69.20, invest those rupees at 9-10% and have Rs 77 by end of the year. They would then swap/buy-back the dollars from RBI by paying the agreed swap rate/forward rate of 3.8%, which is Rs 72. The difference of Rs 77-72 would be the gains made by the banks on this swap deal.
If the banks had bid to buy forwards for such huge amount in open market, it would have pushed the forward premium significantly
The premium on dollar/rupee forward fell by as much as 52 basis points after the auction
The month of March also saw strong inflows from foreign portfolio investors who pumped in Rs in equity and debt combined.
To reduce the short-supply of Rupee, RBI also intervened in open market and bought the dollars
As the financial year was about to end in just two days, banks who did not qualify for auction were reluctant to hold their excess dollars. So, they started selling dollars in the open market and were ready to receive less rupees in return for “next-day delivery” of rupee. Even exporters were waiting to convert their dollar receivables into rupees as due to year-end.
This lead to sudden demand for rupees and spiked the cash-tom and tom-spot rate to as high as 46 paise
The system was also awash with dollars coming as capital flows