RBI’s sell-buy swaps slow rupee’s fall but push up forward premiums, making hedging costlier for foreign investors

Mumbai: The central bank’s sell-buy swaps, wherein it sells dollars in the spot market with a promise to buy back the units on a future date, have played a part in slowing the rupee’s rout but simultaneously caused forward premiums to spike.

Bankers believe this has had an unintended consequence for the currency: Making it expensive for overseas funds to buy rupee-denominated assets due to high hedging costs.

In effect, this could be seen as partially counter-productive as a tool that's intended to give the rupee a firm floor.


"For foreign investors, particularly those who fully hedge their currency exposure, a rise in forward premiums increases the cost of hedging and reduces the attractiveness of the overall rupee return, which could marginally discourage some debt/portfolio inflows,” said Kunal Sodhani, head of treasury at Shinhan Bank India.

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The one-year dollar-rupee forward premium included blended cost rose to 8.65% from 7.40% less than a month ago. Although it retreated to 8.45% on Thursday, foreign investors will still find it expensive to hedge their local investments. To be sure, this reflects comprehensive hedging costs an overseas investor would incur, bankers said.

Two traders said the Reserve Bank of India (RBI) may have shifted its focus on forward market dollar sales Thursday to help cool surging forward premiums that threaten the spot rupee.

Forward rupee premiums for different tenors were seen rising until Wednesday. The rupee, meanwhile, closed a tad weaker at 96.79 a dollar against Wednesday's close of 96.7750. The currency opened the day stronger at 96.68 but came under pressure in the afternoon tracking the rising fuel prices. It remains within sight of its all-time low of 96.96.

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Brent crude prices jumped to $104 a barrel Thursday from $101 earlier.

“In the current environment, the larger impact is likely to be on hedging behaviour—higher premiums may encourage exporters to sell dollars forward while making forward hedging more expensive for importers and borrowers," Sodhani said.

Case for USD Outflow?

Bankers said the situation is such that for large Indian companies with offshore operations, it is much cheaper to borrow from the local market in rupees and swap them into dollars for overseas use.

"Many companies are seriously looking at this alternative because overseas rates have gone up. A top-rated Indian company can get a three-year loan at about 5.50% abroad. With around 3.25% of hedging cost, this loan could go beyond 9%,” said a senior treasury official, who declined to be named. “But if it chooses to borrow 3-year money at about 7.75% here, the cost of swapping it to the dollar is much less, which makes it cheaper to take dollars abroad."

Higher forward dollar premiums and cheaper ways to take money abroad could put further pressure on the rupee, making the RBI’s job of managing the currency more difficult, bankers said.

The RBI on raised its benchmark repo rate to 5.5% in the first such increase since February 2023, but bankers said more policy-rate increases are necessary, especially as the difference between Indian overseas rates has shrunk below historical average.

For instance, the difference between India's 10 year bond (7.24%) and US 10 year security (5.34%) is at 190 basis points now compared with the historical average of 400 basis points.

One basis point is 0.01 percentage point.

"There is immediate scope for this difference to move up to 220 to 225 basis points with India's ten-year bond likely to cross 7.50%. Overall, local rates have to go up. We expect at least 50 to 75 basis points hike in the repo rate this fiscal," said Anshul Chandak, head of treasury, RBL Bank.

Bankers said higher rates will ensure attractiveness for overseas inflows and make Indian paper competitive in the international market. Resultant dollar inflows will support the rupee and reduce pressure on the RBI.

In a post policy note, State Bank of India (SBI) economists said the repo rate could go to 6% after a 50 basis points hike in the next policy in December.

Economists believe \the rupee needs support measures to attract inflows like reducing long-term capital gains tax beyond a reasonable period, widening the effective interest rate corridor by hiking the MSF (marginal standing facility) rate, and continuing with liquidity management measures.

"The weakness in the local currency is likely to continue on persistent dollar outflows," market veteran KN Dey said.