September 9, 2002	Monday	Rajab 1, 1423

The State Bank has started dollar/rupee swap with the banks on a regular basis. The central bank has set up a permanent desk for this purpose in its exchange and debt management department. The setting up of this desk has enabled the SBP to use dollar/rupee swap as a new tool of monetary management.

The concept of swap is not new for the State Bank: In the past it had entered into swap arrangements with a number of banks on more than one occasion to overcome the shortage of foreign exchange. But this time around the concept of swap has been introduced as a regular feature.

Like open market operations (OMOs) that the SBP conduct to inject liquidity into the system or mop up surplus of it, the dollar/rupee swaps will also be struck as and when required. Last week the SBP did make some deals mostly with foreign banks to sell dollars in spot and buy them in forward.

Central bankers say there are many objectives of swaps. They say that by entering into dollar/rupee swap with the banks the SBP can maintain liquidity levels of both local and foreign currencies at the desired levels. Let us see how?

Suppose that the inter-bank market is surplus in rupee liquidity that may impact adversely on the monetary targets—if allowed to continue. In such a situation the State Bank may enter into swap arrangements with the banks that are short in foreign currency. The central bank will sell dollars to them for a certain period —say one month—against rupee with the promise that it will buy back these dollars at the agreed rates after a month. This dollar selling will automatically reduce rupee liquidity as the banks that will be buying dollars from the SBP will pay for them in rupees.

Now suppose that the market is short of rupee liquidity that may upset the monetary targets and also drive the lending rates up. In this situation the State Bank may buy dollars from the banks for a certain period—say one month—with the understanding that it will resell the dollars to them at the agreed rates after a month. This dollar buying will naturally raise rupee liquidity as the SBP will give rupees to the banks from whom it will be buying dollars. “This shows how the dollar/rupee swap can be used for maintaining rupee liquidity within targeted levels,” says treasurer of a foreign bank, Nasim Akbar, who heads Financial Markets Association —a body comprising bankers and inter-bank brokers. “This will also enable the SBP to send signals to the market on interest rate structure,” says former president of the Association and treasurer of another foreign bank, Dr. Naim Abdullah. Both believe that the setting up of swap desk has provided the SBP with a new tool of monetary management. “This was long awaited,” says Akbar.

It is quite practical that the SBP can use the dollar/rupee swaps also to signal the desired change in the interest rates regime. But it does not mean that the swaps can have a direct and instant impact on the interest rates that are dictated by a host of other market forces. The same holds true for the exchange rate.

On both interest rate and exchange rate regimes the impact of the swaps will be indirect. Senior bankers say since the dollar/rupee swaps may change the liquidity levels of both local and foreign currencies—as the case may be—this change will naturally reflect in the pricing of the rupee funds and in the rupee/dollar parity.

Let us see how? Spot dollar buying by the State Bank under swap arrangement will increase rupee liquidity to a level where banks will be forced to invest surplus funds in government papers or make short term lending to other banks at cheaper rates. Of course for a certain period! Because on the maturity of the swap deals the situation will change and the market will see an outflow of rupee funds to the extent of the SBP’s dollar buying.

Similarly spot dollar selling by the SBP through swaps will lower rupee liquidity to a level where it will not be possible for the banks to invest surplus funds in government papers at cheaper rates. Nor they will be able to make short term lending to other banks at the previous low rates. The law of demand and supply will naturally make rupee funds dearer. But for a limited period only. Because the market will witness inflows of rupee liquidity on the maturity of the swap deals in line with the swap volumes.

On the other hand the banks will get additional inflow of dollars when the SBP will be selling dollars in spot and buying them in forward. In this situation the increase in dollar supply level will automatically depreciate its value in the inter-bank market —for a limited period: On the maturity of the swap deals the situation will change and outflow of dollars to the extent of the swap volumes may make it dearer again—if other factors remain unchanged.

Similarly the banks will have to face shortage of dollars in case the SBP goes for big spot dollar buying under swap arrangement.

Naturally then the decrease in dollar supply will make it dearer in the inter-bank market—for a limited period: On the maturity of the swap deals the dollars (equivalent to swap volumes) will flow back into the inter-bank market. And that may lead to a fall in the value of the dollar—if other factors remain unchanged.

Senior bankers say the SBP can also use the swap desk at times to make big external debt payments or fulfil other foreign exchange obligations without drawing down on its forex reserves. Though it does not seem to be a pressing need at the moment because forex reserves are quite large to support big external debt payments— and a major portion of the debt itself has been rescheduled. But at times when there are no big reserves and big debt payments are to be made on time—the swap desk will give a real helping hand to the SBP. In the past the central bank had to swap hundreds of millions of dollars in bulk to remain current on external debt payments when the reserves were too low to support such payments.

Attaining the ability to service external debts without drawing down on the forex reserves is crucial for the SBP for another reason. The IMF-backed three-year poverty and growth reduction facility (PRGF) that is currently in operation in Pakistan does require the SBP to keep a certain amount of foreign exchange at the end of every quarter. It is true that the central bank has more than targeted reserves at present but the possibility of the reserves falling in the remaining two years of PRGF cannot be ruled out.

In addition to all this the swap desk will also enable banks to give short term foreign currency loans to importers/exporters also at times when they do not have enough liquidity in foreign currency. “But that depends on whether the central bank agrees to sell dollars in spot and buy in forward,” warns treasurer of a local bank. He says if the SBP is willing to make this swap then a bank needing foreign currency for his customer will buy spot dollars from the central bank and sell it the same in forward thus raising the required amount of foreign exchange. “But in so doing we will burst our exposure limits and will have to cover that from the inter-bank market,” says treasurer of another bank.

Central bankers say the setting up of dollar/rupee swap desk is in line with the SBP efforts to use as many market-based tools as possible for monetary management and minimise its dependence on moral suasion—the ultimate tool of all central banks.

Moral suasion refers to the ultimate request-cum-threat a central bank has to make to get things done the way it wants. “When we go for moral suasion we do make a request—and at the same time tell the banks: Do not forget who is making the request,” says a central banker.

But he does admit that with the fast-paced liberalization of the financial system in Pakistan there is very little scope for the SBP resorting to moral suasion. “Our job is not to dictate the system. Our job is to send signals through our market-based actions—and a dollar/rupee swap could be one of such actions.”