India banned its banks from offering the most popular instrument for trading the rupee offshore, threatening to squeeze a $149 billion-a-day market in an extreme step to shore up its tumbling currency.
The Reserve Bank of India’s restrictions on non-deliverable derivative contracts will ripple through major currency hubs such as Singapore and London, where trading has exploded over the past decade to about twice the size of the onshore market. The rupee surged the most in 12 years on Thursday.
The policy adds to a late-Friday measure that capped lenders’ daily currency positions locally at $100 million, triggering a scramble among banks to unwind at least $30 billion in arbitrage trades. Such moves risk undercutting years of efforts to deepen India’s currency markets, where growing onshore and offshore liquidity has helped attract foreign investors and support Prime Minister Narendra Modi’s push to boost the rupee’s global use.
“This is again a signal that the central bank is willing to consider harsh steps that are nevertheless regressive and that its focus is on the stability of the rupee rather than liquidity for now,” said Abhishek Upadhyay, an economist at ICICI Securities Primary Dealership.
RBI ramps up rupee support
The regulator is going all out to squeeze a trade that it sees fuelling speculative bets. Investors have typically used offshore contracts known as non-deliverable forwards to build short rupee positions, while banks run arbitrage trades — buying dollars onshore and selling them overseas — to profit from price gaps between the two. Those onshore dollar purchases can add pressure on the local currency, reinforcing the offshore bearish bets.
This activity is mainly driven out of global financial hubs such as Singapore, London and New York, with international lenders like JPMorgan Chase & Co, Standard Chartered Plc, HSBC Holdings Plc and Citigroup Inc dominating the space. Some Indian banks also participate.
The RBI measures amount to a coordinated push to flush out excess bearish rupee positions and speculative trades across the market, according to Kunal Sodhani, head of treasury at Shinhan Bank Ltd in Mumbai. This may come at the cost of reduced liquidity and wider spreads between the onshore and offshore markets, he said.
“Overall, the RBI’s message is unambiguous,” he said. “The FX market is to function as a hedging mechanism aligned with real economic activity, not as a platform for leveraged speculation.”
The rupee has been hitting successive lows despite repeated intervention by the RBI, with pressure intensifying after the Iran war drove up India’s fuel import costs. It has tumbled about 8% over the past year, making it Asia’s worst-performing currency.
The rupee rebounded about 2 per cent to 92.83 per dollar on Thursday as trading resumed after a two-day break. Earlier in the week, it had weakened past the 95 level. Meanwhile, offshore forward points, or the cost of hedging exposure to rupee assets outside India, are near their highest since 2020.
The policy surprises are an attempt to head off imported inflation with a stronger currency. Skyrocketing energy prices have fanned stagflation fears, with oil-importers like India particularly vulnerable. A widening trade deficit, combined with a stronger dollar, has only deepened pressure on the rupee.
This puts the RBI in a dilemma. Raising interest rates to defend the currency may hurt economic growth, pushing policymakers to rely more on other tools. That includes stepping up intervention — which has already contributed to a more than $30 billion drawdown in FX reserves in the first three weeks of March — as well as more direct measures targeting financial institutions. The central bank is due to announce its next rate decision on April 8.
“The RBI cannot use monetary policy to fight this pressure as they are primarily focused on inflation management,” said Gaurav Kapur, chief economist of IndusInd Bank Ltd. That helps to explain the move to target the NDF market, he said, adding that the central bank still has other options, including a potential increase in the cash reserve ratio, as seen in 2013.
On Thursday, the sovereign bond clearing house imposed a 20% volatility margin on dollar-rupee forwards, in yet another step by authorities to tighten control over the currency.
Bond outflows
By curbing NDF activity, the central bank is driving up the cost of hedging currency risk, said Rajeev de Mello, a global macro portfolio manager at Gama Asset Management. That will discourage foreign participation in the local bond market, ultimately pushing up the government’s borrowing costs, he added.
Foreign interest in Indian debt has grown, with about $14 billion flowing into bonds since their inclusion in JPMorgan’s flagship index in June 2024, underscoring the need for hedging. But flows have taken a hit from the latest curbs. On Monday, index-eligible bonds saw outflows of ₹3,285 crore ($352 million), the biggest single-day exit in 10 months.
A key question now is how long the RBI can sustain such measures. When it adopted similar measures in December 2011, the rupee strengthened from 54.3 to below 50 in about a month — but at the cost of liquidity drying up, said Madhavi Arora, chief economist at Emkay Global Financial Services Ltd. However, volumes recovered within a few months, and banks, after an initial hit to shares, rebounded strongly.
“If the similar playbook follows this time around too, rupee would be a sharp gainer over next one week or so, as the banks unwind their speculative positions,” she said. While lenders may face short-term mark-to-market losses, once the currency stabilizes and liquidity conditions normalize, the focus will shift back to credit growth, she added.
This time, however, the impact could be more disruptive as the scale of FX operations has ballooned.
“Ten years ago, people didn’t take such large positions,” said Jayesh Mehta, chief executive officer of DSP Finance Private Ltd. with more than three decades of experience in FX and bonds. Today, the size of trades — including relative-value bets across currencies — can dilute the effectiveness of the RBI’s interventions, he added.
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