RBI's New Forex Measures Could Boost Rupee but Risk Liquidity

In a significant development for the Indian currency market, forex dealers anticipate a notable increase in the rupee's value against the dollar following recent measures announced by the Reserve Bank of India (RBI). This could mark one of the sharpest gains for the domestic currency in recent history. However, concerns are rising regarding a potential freeze in market activities, as the RBI's stringent anti-speculation policies may inadvertently hinder legitimate market-making and reduce interbank liquidity, impacting corporate hedgers who rely on these transactions.

Oil companies, typically the largest daily purchasers of dollars in the market, are expected to utilize a special window provided by the RBI to acquire foreign currency. At the same time, the introduction of stricter documentation requirements may complicate other commercial dollar purchases. The RBI's dollar sales, coupled with expectations of a stronger rupee, could encourage dollar holders to sell, thereby exerting additional downward pressure on the dollar's value.

Ashhish Vaidya, head of treasury at DBS Bank, commented on the situation, stating that while the recent measures will bolster the rupee in the short term, they could lead to a rapid decline in forex market liquidity. He emphasized the need for operational clarity from the RBI to restore confidence among market participants in quoting two-way prices.

The introduction of a 20% Foreign Exchange Risk Reserve (FERR) by the RBI means that banks must now set aside 20% of interest-free cash with the central bank when selling forex derivatives to importer clients. This requirement has created uncertainty among dealers regarding how and when this reserve will be debited, complicating the pricing of trades. Clarity is particularly sought in the context of cross-currency swaps, which are often used to hedge external commercial borrowings.

As banks grapple with these new regulations, they face the dilemma of whether the 20% cash reserve applies to the entire swap contract or just the interest portion. This requirement could lead to significant opportunity costs for banks, estimated at around 6.5% to 7% in lost interest, which they may pass on to corporate clients through increased swap spreads, making hedging less economical. Importers who have secured forward contracts to manage their upcoming import bills may find themselves at risk of incurring substantial losses if the rupee appreciates sharply against the dollar, highlighting the complexities introduced by the RBI's new measures.