MUMBAI, March 30 - The Reserve Bank of India (RBI) tightened rules on banks' foreign exchange exposures at the end of last week, capping net open rupee positions at $100 million. The change - a shift from the previous limit expressed as 25% of a bank’s total capital to an absolute dollar ceiling - briefly supported the beleaguered rupee on Monday, yet bankers and market strategists caution the measure will dent banks' trading gains and may not alter the wider forces pressuring the currency.
The central bank's directive arrived as the conflict involving Iran, the U.S. and Israel has pushed oil prices higher and tightened gas supplies, intensifying economic risks, amplifying currency volatility and raising concerns about capital outflows from emerging markets. India is especially exposed because it imports about 90% of its oil needs, a dependence that is expected to widen the country’s current account deficit as crude costs rise.
Heavy foreign investor selling drove the rupee to a record low of 94.81 against the U.S. dollar on Friday. On Monday the currency opened roughly 1% stronger at 93.60 before trimming those gains later in the session.
"This is a move that reflects the RBI’s desire to stabilise the currency in the immediate term while noting that the FX interventions via dollar sales alone may not be cutting it since the risks from the oil price rise are so large," said Dhiraj Nim, an economist and FX strategist at ANZ. He cautioned, however, that "Near-term stability is likely but (the rule change) doesn’t rewrite the fundamental pressures."
Targeting arbitrage
The new limit explicitly targets a cross-market arbitrage that had expanded as offshore markets factored in faster rupee weakness stemming from the Iran conflict than onshore participants. Four bankers said that as offshore prices priced in steeper rupee falls, banks accumulated positions that exploited the spread between onshore and offshore contracts.
A person familiar with the central bank’s thinking told market participants that banks had collectively built up arbitrage positions of between $25 billion and $35 billion. Those flows exerted downward pressure on the spot rupee as banks purchased dollars domestically while selling them in offshore non-deliverable forward (NDF) markets.
"By limiting the positions to just onshore positions, the RBI seems to have targeted the popular trade where banks buy USD/INR onshore and sell USD/INR NDF offshore to benefit from the spread," Michael Wan, senior currency analyst at MUFG Bank, said.
The RBI did not immediately respond to an email seeking comment.
Profit hit for bank treasuries
Trades that were profitable when constructed are now set to produce significant losses, bankers said. The cost of hedging in the NDF market jumped sharply: 1-month dollar/rupee NDF forward points climbed to a high of 100 paise on Monday, well above the 3-5 paise spread at which many of these arbitrage trades were originally entered.
The wider the gap, the larger the potential losses for banks forced to unwind positions, because they may exit at much higher forward points than those at which they sold or bought to establish their positions.
The late-Friday directive prompted a flurry of weekend calls from banking groups seeking more time to comply with the April 10 deadline set by the RBI to meet the new limits. Concerned about what some described as a potential "major dislocation," several bankers requested a three-month window to wind down exposures - a period that would allow many of the positions to mature naturally.
Market participants estimate that on an arbitrage book of around $30 billion, each 1 paisa widening beyond the locked-in spread equates to a 300 million rupee ($3.20 million) loss. "If the spread between NDF and onshore markets stays elevated around current levels, banks could be staring at meaningful losses from the trades," said Kunal Kurani, vice president at forex advisory firm Mecklai Financial.
Following the rupee's early Monday rebound, Kurani said he had been advising importer clients to secure FX hedges.
Implications and outlook
While the RBI’s move has the immediate effect of constraining a popular form of arbitrage that pressured the rupee, traders and analysts said it does not remove the underlying vulnerabilities facing India’s external position. The confluence of higher oil prices and geopolitical risk continues to point to a larger import bill and a wider current account deficit unless those macro factors ease.
For banks, the policy change crystallises a trade-off: it may reduce rupee volatility in the near term but does so at the cost of crystallised losses and lower treasury revenues for institutions that had leveraged cross-border spreads. How sizeable those losses become will depend on how long NDF-onshore spreads remain elevated and how quickly banks can run down their arbitrage books without triggering further market dislocation.
Conversion rate: ($1 = 93.8700 Indian rupees)