[Fed Tapering:Part2 of 2] Measures to immunize Indian Economy against negative impacts of Fed Tapering, Currency Swap, Dollar Swap, FCNR swap, Brics bank explained

FII sharemarket rupee weakens

[Fed Tapering:Part2 of 2] Measures to immunize Indian Economy against negative impacts of Fed Tapering, Currency Swap, Dollar Swap, FCNR swap, Brics bank explained

  1. Prologue
  2. Desi Vaccine against Fed Tapering?
  3. Volatility in Forex market: Why should Rajan intervene?
    1. [More onions 1] BRICS bank
    2. [More onions 2] Currency Swap agreement with Japan
    3. [More onions 3] Dollar swap for Oil companies
    4. [More onions 4] FCNR swap
  4. Summary
  5. Mock Questions

Prologue

So far, we learned

  1. What is Quantitative Easing click me
  2. What is fed tapering? What will be its (negative) consequences on Indian economy? click me
  3. Now third important question (for GS2): “what has RBI (and Government) done to immunize Indian economy against the negative impacts of Fed tapering.”

Desi Vaccine against Fed Tapering?

Fed Tapering’s worst case negative outcome = BoP crisis. BoP crisis needs three pre-conditions. Hence RBI and Government must to stop those pre-conditions from happening.

BoP Crisis precondition How to stop?
1.Huge CAD
  • RBI helped oil companies to arrange dollars easily. (dollar swap facility)
  • Govt. took some initiatives / subsidies / schemes to boost exports. (not going into details here, or article will run 5 miles long)
2.Low Capital surplus
  • Govt: relaxed FDI norms, changed environment minister to quickly give clearance to POSCO etc.; set up Project monitoring group in PMO to hasten file clearance. (all these done to boost investors’ confidence so more FDI, FII can come, despite fed tapering)
  • RBI – reformed FCNR-accounts, so NRIs can earn more interest from their (dollar) deposits in desi banks.
3.Backup against BoP/volatility Explained below.

Mismatch between Current account vs capital account, creates two negative outcomes

  1. In every case: Rupee weakens because onion (dollar) supply gets low in the market. (in other words “volatility in Forex market”.)
  2. in Worst case: BoP crisis.

Volatility in Forex market: Why should Rajan intervene?

There are two types of exchange rate regimes

FIXED EXCHANGE RATE REGIME FLOATING (OR FLEXIBLE)
RBI “fixes” the exchange rate say $1=50 Rs. If you can’t get dollars at that price, you can walk in Rajan’s cabin, deposit fifty rupees and get one dollar from his forex-reserve. RBI doesn’t fix the exchange rates. It lets the market forces of supply-demand to decide the exchange rate.
Discontinued after 1992-93, because RBI did not have enough Forex reserve to fullfill its commitment. (thanks to BoP crisis) Started from 1993.

FII sharemarket rupee weakens

how can RBI prevent fall of rupee

  • But free market mechanisms have their limitation. Sometimes there is extreme volatility because of speculation or external events. Say 1$=50 Rs., tomorrow 1$=60 Rs., next day its $1=70 rupees. Such volatility =bad for business planning, importers/exporters cannot make long term projections.
  • Therefore, in case of extreme volatility, RBI does intervene. For example,
  • May-Sep 2013: Rumors of Fed tapering => large outflow of FII => rupee was weakening- almost near 69-70 level.
  • At that time, Rajan started selling onions (dollars) from his own his own godown (forex reserve storage)=> onion (dollar) supply increased , prices fell down and rupee went back to 63-65 range.

Rupee dollar exchange rate graph 2013-14

MEANING, IF Rajan wants to immunize Indian economy against the bad effects of FED TAPERING (=Exchange rate volatility and BoP crisis), then

  • He must build large stock of onions (dollars) in his godown (forex reserve). AND OR
  • He must make deals with others, who will supply him onions (dollars) in case of emergency (e.g. IMF, BRICS, Japan etc.)
  • To accomplish ^this, following big steps taken in recent times.

Timeline Fed Tapering and steps taken by India

[More onions 1] BRICS bank

March 2013: BRICS leaders decided to setup set up a Development Bank.

Benefit:

  1. funding infrastructure projects in member nations.
  2. Member nation can get funding from it, in case of financial crisis/BoP crisis. For this purpose, BRICS bank will have a separate emergency-fund of 100 billion USD.

Ok but where did these 100 billion dollar came from?

BRICS development Bank

China 41
Russia 18
India 18
Brazil 18
South Africa 5
total Bn 100

Limitation: will start operating from 2015.

[More onions 2] Currency Swap agreement with Japan

Currency Swap Agreement meaning benefits mechanism

  • Currency swap agreement are signed between RBI and Bank of Japan.
  • Benefit: in case of emergency, RBI can get dollars from Japan and vice versa. How?
Crisis in India Crisis in Japan
Rajan sends rupee suitcases to Japan, they send back dollar suitcases (@reasonable price). Upto 50 billion dollars. Bank of Japan will sent Yen suitcases to India, Rajan will send them dollar suitcases  in return. (upto 50 billion dollars.)
  • In short, Currency swap= you scratch my back with dollars, I’ll scratch yours (incase of BoP crisis or Volatility in exchange rates).
  • It is not a new thing- we already have this type of agreement with Japan since a long time.
  • BUT, given the fear of Fed Tapering, we increased the amount of this backup plan.
Upto sept. 2013 15 billion$ currency swap agreement.
Sep’13 Increased it to 50 billion$ (because rupee was moving towards 65-70 range.)

Additionally,

  • We’ve Currency swap agreement with Bhutan ($ 100 million).
  • China also interested in currency swap agreement with India, but formal-deal yet to be signed
  • China already has currency swap agreement with S.Korea, HongKong, Malayasia, Indonesia, Singapore, Iceland, Newzeland and even chillar countries like Belarus, Uzbekistan and Mongolia.
  • India should also explore the same – find more gangmembers to join Desi Currency swap club.

[More onions 3] Dollar swap for Oil companies

  • IOC, HPCL and BPCL: these three oil companies alone need ~8.5 billion US dollars every month to import crude oil.
  • August 2013: 1$= ~69 Rs. (Given the fears of fed tapering).
  • So, RBI announced dollar swap facility for those oil companies.

Mechanism is similar to currency swap:

  • Oil companies give rupees to RBI and get dollars in return.
  • After few months, they’ll have to return those dollars. (i.e. Oil company will have to buy fresh dollars from some xyz forex trader, give it to RBI and get their rupee suitcases back).
  • In April 2014: they’ll have to return ~12 billion USD to RBI.

How does dollar swap help?

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