RBI measures: Rupee to gain sharply but forex liquidity likely to dry up

MUMBAI: Forex dealers expect a gap opening in the rupee-dollar exchange rate, with the domestic unit likely to record its sharpest gain in recent times. However, there is also a looming market freeze, with RBI's aggressive anti-speculation measures risking paralysis of legitimate market-making, choking interbank liquidity and inadvertently penalising genuine corporate hedgers. Oil companies, normally the market's largest daily dollar buyers, will source dollars through RBI's special window, while stricter documentation rules could slow other commercial purchases. Meanwhile, RBI's dollar sales and expectations of rupee appreciation may prompt holders to sell dollars, adding to downward pressure on the dollar. "While the weekend measures will support the rupee in the immediate term, liquidity in the forex market could dry up very quickly. Desks need substantial operational clarity from RBI before they have the confidence to quote two-way prices again," said Ashhish Vaidya, head of treasury at DBS Bank. RBI's new 20% Foreign Exchange Risk Reserve (FERR) means selling forex derivatives to an importer client now forces the bank to lock up 20% interest-free cash with RBI. Because dealers do not yet know how or when this reserve will be debited, they cannot accurately price their trades. One area where clarity is sought is cross-currency swaps, such as those used to hedge external commercial borrowings (ECBs), or coupon-only and principal-only swap structures. In a foreign currency borrowing swap, repaying the loan principal is a capital-account transaction, exempt from the 20% reserve. However, paying periodic interest on the loan is a current-account transaction. The question before banks is: "If an Indian company buys forward dollars to hedge its upcoming loan interest, does the lending bank have to park 20% cash with RBI on just the interest portion or on the entire swap contract?" Locking up 20% in idle cash with the central bank carries an opportunity cost of roughly 6.5% to 7% in lost interest. Banks will pass this direct cost on to corporates through steep swap spreads, making standard hedging uneconomical for genuine borrowers. Importers who prudently locked in forward contracts or currency futures to cover upcoming import bills are "long" on the dollar, meaning they gain if the dollar rises and incur paper losses if the rupee strengthens. If the rupee suddenly surges by more than Rs 1 against the US dollar, these long-dollar positions could incur substantial mark-to-market (MTM) losses, which the importers would have to cover. "Slashing the threshold from $100 million to $5 million for derivative transactions without underlying merchant transactions creates an administrative headache. Instead, it would have been cleaner to simply draw a line between retail and wholesale market participants," said a dealer.