RBI's rupee defence may drain banking liquidity, ease currency pressure

Mumbai, The Reserve Bank of India's (RBI) measures to curb rupee volatility could ease near-term depreciation pressure and help withdraw surplus liquidity from the banking system, according to research reports.

The measures, including a dedicated dollar window for oil marketing companies through designated banks and higher costs for certain foreign exchange hedging transactions, are expected to reduce dollar demand in the spot market and curb speculative positions against the rupee.

"The immediate reaction on INR is expected to be very favourable-likely move of USDINR towards sub-95 cannot be ruled out. Forward premia is likely to soften as OMCs and other importer hedging gets contained," Kotak Mahindra Bank said in its report, while cautioning that the global environment remains uncertain.


IDFC FIRST Bank said the measures were expected to result in a near-term reduction in USD/INR and lower forward premiums, but added that global factors and balance-of-payments dynamics would determine the currency's medium-term trajectory.

The RBI, in its October 10 circulars, barred authorised dealers from allowing users to rebook cancelled rupee-linked foreign exchange derivative contracts, while continuing to permit rollovers on maturity subject to existing regulations. It also reduced the threshold for undertaking foreign exchange derivative transactions without establishing an underlying exposure to USD 5 million from USD 100 million, across authorised dealers and recognised stock exchanges.

The central bank also introduced a Foreign Exchange Risk Reserve (FERR), requiring authorised dealers to maintain with the RBI, in cash, 20 per cent of the rupee equivalent of the notional amount of each rupee-linked foreign exchange derivative contract exceeding USD 2 million, where the transaction is undertaken to hedge current account exposures involving the purchase of foreign currency against the rupee. The RBI said the measures were aimed at strengthening market discipline and ensuring appropriate risk management while maintaining an orderly and transparent foreign exchange market.

The higher costs associated with the Foreign Exchange Risk Reserve (FERR) could also discourage some importers from hedging their currency exposure, reducing dollar demand and easing forward premiums. Kotak estimates that hedging costs could rise by 1-1.6 per cent, while IDFC FIRST Bank estimates an increase of around 1.5 per cent.

However, the relief to the rupee may be limited if external pressures persist. IDFC FIRST Bank flagged elevated crude oil prices, foreign portfolio outflows and weak underlying capital flows as factors that could sustain depreciation pressure.

The effectiveness of the measures will also have implications for domestic monetary conditions.

IDFC FIRST Bank said that if the steps reduce depreciation pressure by curbing speculative demand and changing hedging behaviour, the RBI could take a gradual approach towards further rate hikes.

The bank expects the terminal repo rate to be in the 6-6.25 per cent range.

The RBI raised the repo rate by 25 basis points at its October monetary policy meeting and shifted its stance to calibrated tightening.

On the liquidity front, IDFC FIRST Bank estimates that core liquidity surplus could fall to around Rs 2 lakh crore by March 2027 from Rs 10.4 lakh crore on October 2, as currency leakage and balance-of-payments pressures add to the impact of the RBI's liquidity operations.

Kotak Mahindra Bank estimates that the measures could withdraw around Rs 1.5 lakh crore of durable liquidity if they continue for another month. It also expects further liquidity withdrawal through open market bond sales and foreign exchange intervention.

The RBI has announced an open market sale of government securities worth Rs 25,000 crore for October, following earlier liquidity-draining operations.

It also announced an increase in the daily maintenance of the Cash Reserve Ratio (CRR) to 99 per cent from 90 per cent, following a review of liquidity conditions.