Context: The Reserve Bank of India (RBI) conducted a $ 5 billion dollar-rupee swap auction as part of its liquidity management initiative.

About Dollar–Rupee Swap

• It’s a forex tool whereby the central bank uses its currency to buy another currency or vice versa.
• In a Dollar–Rupee buy/sell swap, the central bank buys dollars (US dollars or USD) from banks in exchange for Indian Rupees (INR) and immediately gets into an opposite deal with banks promising to sell dollars at a later date.
• In a dollar–rupee sell/buy swap it sells USD in exchange for INR and promises to buy dollars from banks after some years.
• The swap auction can be done in the reverse way also when there is shortage of liquidity in the system. 
• The RBI then buys dollars from the market and releases an equivalent amount in the rupees.

Impact

• It will lead to infusion of dollars and sucking out of the rupee from the financial system.
• The central bank’s move will reduce the pressure on inflation and strengthen the rupee.
• The major impact will be that liquidity will shrink. 
• The RBI normally brings down liquidity in the system when inflation threatens to rise sharply.
• Forex swaps are intended for liquidity management. 
• Therefore, their impact on currency is only incidental.
• With crude oil prices rising sharply in the wake of the Russia-Ukraine war, inflation is set to rise in the coming days.
• Foreign portfolio investors have been pulling out funds from India.
• The RBI resorting to selling USD in two tranches will keep a check on Rupee’s volatility and help curb its depreciation to some extent.
• For the bond market, the exercise may have a pronounced impact.
• Bond yields are already on an incline. Liquidity intervention through swaps indicates the RBI’s plan to use a different toolkit rather than the traditional ones, and this leaves room for the central bank to buy bonds when needed. Consequently, the strategy will contain bond yields.