Kolkata: The Reserve Bank of India (RBI) has taken a slew of steps since Saturday to help lift the rupee to what Governor Sanjay Malhotra described as its "correct" value. These measures have helped the rupee recover to 95.28 a dollar, about 150 paise over two days. An immediate fallout is the reduction in speculative bets on the currency and discouraging over-hedging by companies in anticipation of further rupee depreciation. An inevitable inflation in hedging costs, a natural outcome of the reserves to be set aside by banks against client exposures, has caused some noses to wrinkle in the importer community.
Separately, total removal of the dollar needs of three state-run fuel retailers from the spot rupee market reduces the pressure on the currency.
Here's an ET explainer on the measures taken by the central bank and their impact.
Introduction of Foreign Exchange Risk Reserve (FERR)
A first-time measure imposing a 20% cash reserve requirement on large forex derivatives contracts over $2 million. This means banks will have to set aside funds as a percentage of their total exposure, and that money will no longer be available for onlending until the exposure is fully cancelled.
For instance, for a $10 million hedging contract for a client, a bank will have to keep around ₹19 crore everyday with the central bank until the expiry of the contract. This money is not available for lending.
Hence, banks will have to pass on this cost to their clients. This would inflate the hedging cost for importers by at least 150 basis points (one basis point is a hundredth of a percentage point) and, therefore, they would be discouraged to hedge their exposure, experts said.
FERR Impact on the Forwards Markets
Another fallout of the FERR curbs is an immediate cut in the rates on forward premium, as the aggregate demand for hedging itself would reduce. Since importers would keep open positions, it would ultimately soften forward premium rates, currency experts believe. Softening forward premiums will also help reduce pressure on the spot rupee in the local market.
However, a section of the importers is worried their cost would climb significantly as the funds needed to hedge will eat into their working capital buffers, potentially requiring them to borrow to plug the gap.
Extension of FERR restrictions for contracts with overseas entities
The regulator Monday widened the ambit of FERR, extending the rule for non-deliverable contracts involving rupee to non-resident customers, only for the purpose of hedging. The move also eliminates the probability of dollar hoarding by companies and importers because of the steep FERR costs, limiting their dollar exposure to genuine and foreseeable business needs.
Threshold for foreign exchange derivative transactions reduced
The limit has been reduced to $5 million equivalent from $100 million across all authorised dealers. This will curb speculative trading in the rupee. A corresponding reduction has been introduced in exchange-traded currency derivatives involving the rupee, across stock exchanges taken together.
Restrictions on rebooking of cancelled foreign exchange derivative contracts
Banks cannot allow users to rebook any previously cancelled foreign exchange derivative contract involving the rupee - whether deliverable or non-deliverable. Rollover of foreign exchange derivative contracts on maturity shall continue to be permitted.
Special dollar window for State-run oil retailers
The RBI would use its own dollar stockpile to meet the daily dollar needs of Indian Oil Corp, Bharat Petroleum Corp and Hindustan Petroleum Corp. This reduces dollar demand in the spot market, easing the pressure on rupee.
This would also mask the underlying pressure on balance of payments while dollars will be drained from the central bank's foreign exchange reservess. The Reserve Bank of India opened this window Monday, albeit for a temporary period.
Stricter verification
RBI tells banks to obtain additional documentation for verification of underlying exposures. This will prevent users from entering into foreign exchange derivative contracts involving the rupee to hedge contracted exposures, using the same underlying exposure that has been hedged with any other bank. Banks have to keep the documents for a minimum two-year period.
Overall views of forex market and treasury professionals
Economists see these measures as tactical steps to support the rupee, not structural solutions ensuring its durable stability. They believe that defending the rupee amid the continued geopolitical headwinds would be a costly policy trade-off, requiring broader capital market reforms to encourage stable and long term foreign capital inflows.
India still levies a security transactions tax, even when the long-term capital gains tax was reintroduced in 2018, and increased it to 12.5% last year. Experts suggest a broader response spanning lowering of taxes, exchange-rate flexibility and further monetary policy tightening to bolster the rupee.