India’s rupee defence raises question of how far RBI will go

Excess cash in India’s banking system has surged amid inflows from the forex mobilisation programs.

The RBI took the steps early Saturday as the rupee again neared a record low. They include opening a dollar window for state-owned oil refiners and introducing a reserve requirement for foreign-exchange derivatives, similar to one used by China’s central bank. The moves come just after the RBI raised interest rates on Wednesday and signaled it was open to further monetary tightening.

The rupee is poised to rally when trading resumes Monday, with analysts expecting the RBI to defend the 97-per-dollar level. Sustaining any gains may prove harder, however — oil prices remain stubbornly high, while overseas funds have pulled more than $30 billion from Indian equities this year.

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“It is not easy to constantly act as a shield when pressure keeps building up,” said G. Mahalingam, a former RBI executive director who was part of a 2019 task force set up to examine overseas rupee trading. “The steps are some of the strongest we have seen since the taper tantrum. The central bank is building up layers of defenses as the Middle East war shows signs of intensifying and inflows are drying up.”

The RBI has already taken several steps to bolster its foreign-exchange resources. Its diaspora deposit program raised a record $133 billion, swelling its forex reserves to nearly $800 billion in early September. But the pressure to defend the currency has since drained $51 billion from reserves in the past four weeks.

The rupee has weakened 7% this year, the worst performance in Asia. RBI Governor Sanjay Malhotra said it was undervalued on some gauges, and that markets can be irrational in the short term. The currency closed slightly above its record low of 96.9650 per dollar on Friday.

The measures build on series of actions the RBI has taken to support the rupee. Earlier, it limited daily net open positions for banks at $100 million and barred lenders from offering clients non-deliverable contracts rupee contracts, a restriction it later rolled back. In June, the authority unveiled its diaspora deposit program days after New Delhi removed taxes on bond investments by global funds.

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The latest steps target demand in the foreign-exchange derivatives market. For the first time, the RBI introduced a foreign-exchange risk reserve, requiring lenders to hold with the central bank the rupee equivalent of 20% of the notional value of each derivative transaction above $2 million. The People’s Bank of China has a similar tool to manage pressures on the yuan by varying the reserve requirement on forward contracts.

The RBI also said canceled forward contracts cannot be rebooked. It lowered the limit on foreign-exchange derivative transactions without proof of an underlying asset to $5 million from $100 million. While the moves may help steady the rupee, the curbs on the derivatives market may also push up hedging costs for companies seeking to manage their currency exposure, traders said.

The cost of hedging dollars for a year has surged by more than 100 basis points over the past two months as the central bank has been doing sell/buy swaps to soak up surplus liquidity. Excess cash in India’s banking system has surged amid inflows from the forex mobilization programs.

The measures may curb some demand for dollars, but they don’t ease the pressure from energy prices and foreign fund outflows, according to Dhiraj Nim, forex strategist at Australia & New Zealand Banking Group in Mumbai.

“It buys time but doesn’t change the picture: oil prices and capital flows will still decide the rupee’s direction,” he said. “The coming week’s reserves data and rupee moves will show how well this is working.”