RBI Policy Moves Boost Rupee, Yet Jeopardize Forex Market Liquidity

Forex dealers anticipate a gap opening in the rupee-dollar exchange rate, with the domestic currency likely posting its sharpest gain in recent memory. However, RBI’s aggressive anti-speculation measures loom large, risking paralysis of legitimate market-making, choking interbank liquidity and inadvertently penalising genuine corporate hedgers.

Oil companies, traditionally the market’s largest daily dollar buyers, will redirect purchases through RBI’s special window, while stricter documentation rules may slow other commercial transactions. Meanwhile, RBI’s dollar sales and expectations of rupee appreciation may prompt holders to sell dollars, adding downward pressure on the greenback.

While the weekend measures will support the rupee in the immediate term, forex liquidity could dry up swiftly. Dealers require substantial operational clarity from RBI before mustering the confidence to quote two-way prices again,” said Ashhish Vaidya, head of treasury at DBS Bank.

RBI’s introduction of a 20% Foreign Exchange Risk Reserve (FERR) now forces banks to lock up 20% interest-free cash when selling forex derivatives to importer clients. As dealers remain uncertain about how or when this reserve will be debited, accurate trade pricing becomes challenging.

A key area of clarity surrounds cross-currency swaps used to hedge external commercial borrowings (ECBs), including coupon-only and principal-only structures. In such arrangements, repaying the loan principal constitutes a capital-account transaction exempt from the 20% reserve, whereas paying periodic interest falls under a current-account transaction.

This raises a critical question for banks: when an Indian company buys forward dollars to hedge upcoming loan interest, must the lending bank park 20% cash with RBI on just the interest portion or the entire swap contract?

Locking 20% in idle cash carries an opportunity cost of roughly 6.5% to 7% in lost interest. Banks will pass this direct cost to corporates through steep swap spreads, rendering standard hedging uneconomical for genuine borrowers.

Importers who prudently locked in forward contracts or currency futures to cover upcoming import bills are “long” on the dollar—gaining if the dollar rises, incurring paper losses if the rupee strengthens. A sudden rupee surge of more than Rs 1 against the US dollar could trigger substantial mark-to-market (MTM) losses, which importers must cover.

Slashing the derivative transaction threshold from $100 million to $5 million, without requiring underlying merchant transactions, creates an administrative quagmire. A dealer noted it would have been cleaner to simply delineate between retail and wholesale market participants.

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