Hedging dollar interest payments on foreign currency non-resident (bank), or FCNR(B), deposits is set to become costlier for banks, with the Reserve Bank of India (RBI) requiring them to park cash equivalent to 20 per cent of the exposure under its Foreign Exchange Risk Reserve (FERR) framework.
The 12-month dollar-rupee forward premium has risen by 102 basis points in October so far, increasing the cost of hedging future dollar payments. The premium, which reflects the difference between the forward and spot exchange rates, rose to 4.38 per cent on Thursday from 3.36 per cent at the end of September.
Banks have raised a large pool of FCNR(B) deposits through the RBI’s special swap window. Inflows were higher than expected, at $133 billion against the earlier estimate of $75-100 billion, prompting the RBI to shorten the window to August 31 from September 30. The swap window covers only the principal of these deposits. The interest due on them is not covered, leaving banks to arrange the hedges themselves.
Banks are assessing how best to hedge the interest component of their FCNR(B) dollar exposure. Some have hedged through forward contracts and other derivative transactions, while others have not fully hedged it. Banks could choose to retain some unhedged exposure if they expect the rupee to remain around current levels, though their decisions would depend on their outlook for the currency.
“Banks with a strong overseas presence might have it easier, but nobody would like to keep such a large amount of un-hedged position,” said a senior executive at a state-owned bank.
The RBI introduced FERR to curb volatility in the rupee. The reserve is equivalent to 20 per cent of the rupee value of the notional amount of eligible foreign exchange derivative contracts. It applies to specified rupee-linked contracts where users buy foreign currency to hedge current account transactions and the notional value exceeds $2 million. Banks must also maintain the reserve for eligible contracts undertaken to hedge currency risks on their own assets and liabilities.
Under the new rules, transactions undertaken from October 12 onwards are subject to the revised guidelines, whether they are fresh contracts or rollovers. The RBI has also restricted the rebooking of cancelled foreign exchange derivative contracts.
The reserve is adding to hedging costs because the funds parked with the RBI do not earn interest. Banks must maintain the reserve daily for each eligible transaction and keep it in place until a day after the derivative contract terminates.
The increase in forward premiums comes as banks and customers adjust their positions following the new rules. Market participants expect the rupee to weaken over the longer term despite its recent recovery, prompting importers to use current levels to lock in forward dollar purchases.
“It is a problem that banks are trying to figure out. Some large banks with natural hedging went in very aggressively for deposits, but others like us did not. A lot depends on how Rupee moves,” said a senior banker at a private bank.
Banks are advising some customers to book shorter-dated forward contracts of two to three months rather than hedge their entire exposure for longer periods. This is in the hope that market conditions will stabilise and the restrictions may be reviewed in the coming months, market participants said. However, there is no certainty that the RBI will withdraw the measures.
