Indian banks face greater uncertainty after the Reserve Bank of India (RBI) prohibited banks late on Wednesday from providing rupee non-deliverable forwards to resident and non-resident clients, a restriction designed to halt a spike in corporate arbitrage activity observed on Monday. Four bankers, speaking on condition of anonymity because they were not authorised to speak publicly, said the curbs will make it harder and more expensive for lenders to reduce arbitrage positions the central bank has asked them to trim.
The RBI’s measure effectively directs lenders to cut positions that had been viewed as lucrative and relatively low-risk but which the regulator said were adding pressure to the rupee. Banks had relied on corporate arbitrage flows on Monday to help pare down exposures in line with earlier RBI instructions. With corporates barred from exploiting price differences between the onshore and offshore markets from Thursday, that source of relief has been closed off, bankers warned.
"Banks that did not cut on Monday and chose to wait will now have to pay a much steeper price," said a senior treasury official at a private sector bank. "The market knows they need to cut positions and have little choice, and will demand a premium."
Bankers estimate sizeable arbitrage positions remain. Of an estimated $30 billion to $40 billion in arbitrage exposure, only about 50% to 60% was unwound on Monday, leaving a substantial overhang in the system. A treasury official said his bank, together with most foreign banks, had lowered positions to within RBI limits on Monday, while many state-run banks had not yet fully exited.
Those institutions that still hold positions now confront a steeper cost of exit after Wednesday’s measures. The expense of reducing holdings to RBI-specified levels depends heavily on the spread between the onshore rupee market and the offshore non-deliverable forward market. A wider spread increases the cost of unwinding positions and therefore magnifies potential losses for banks.
In recent days, the 1-month tenor spread widened to nearly 100 paise on Monday before narrowing to roughly 30-40 paise as corporate arbitrage activity provided relief. With those corporate flows curtailed by the RBI, the spread widened again to about 100 paise on Thursday, lifting the exit costs banks now face.
The RBI said its clampdown on banks’ position limits was intended to support the rupee, which had come under pressure from persistently high oil prices linked to the Iran war. But the effectiveness of that clampdown was reduced when corporates moved to exploit arbitrage opportunities, a development that contributed to the rupee sliding to an all-time low of 95.21 on Monday.
Market participants and analysts framed the latest restrictions as an effort to close a loophole that had impeded the currency’s recovery. "The latest set of measures by the RBI marks a clear and coordinated shift towards tightening speculative activity and reasserting control over rupee dynamics," Kunal Sodhani, head treasury at Shinhan Bank, said.
Implications for banks and markets
The RBI’s prohibition on banks offering rupee NDFs to clients removes a channel that had been key to arbitrage unwinds. Banks that relied on corporate counterparties to absorb or reverse positions now must find alternative, and likely costlier, means to trim risk. The widening onshore-offshore spread raises immediate mark-to-market losses and elevates the premium counterparties will demand for trades that reduce a bank’s exposure.
How individual banks manage these exits will determine near-term balance sheet impacts and could influence liquidity in both onshore and offshore rupee markets. State-run banks, which were reported to be less advanced in reducing exposures, may face larger exit costs if they continue to hold more substantial positions.