RBI Imposes Limits On Rupee Positions For Banks: How Will It Impact Lenders

In a bold move, the Reserve Bank of India (RBI) has imposed limits on banks on their net open rupee positions in the foreign exchange market. The decision comes against the mounting pressure on rupee due to surging crude oil prices amid the Iran war.

The decision dated March 27 directed authorised dealer banks to reduce their net open rupee positions to $100 million by April 10. This indicates shrinking flexibility of the Reserve Bank of India (RBI), in the backdrop of depleting foreign exchange reserves, with around $11.41 billion worth of reserves washed out during the week ended March 20 alone.

The RBI intends to curb speculative bets taken on the currency in the foreign exchange market. However, the move could also force sudden unwinding of arbitrage trades taken by banks between the non-deliverable forward (NDF) market and the onshore markets. This will leave banks exposed to possible losses on those trades.

Banks execute forward rupee arbitrage trades based on the price differences between the rupee spot markets and the offshore NDF markets, and rely on the divergence between local forward rates and international markets. This acts as a hedge for the banks against volatility in currency. In order for these trades to work, banks bought dollars in the local market and sold offshore, with coupled with the continued fall in rupee is a net import of dollars for banks, adding to the pressure on rupee. In recent months, arbitrage trades by banks to cover their forward positions have increased due the persistent near-term risks posed by the ongoing Iran war. The limits of net open forward positions will help reduce the excessive arbitrage trades in the market, and thus lift up some pressure on the rupee.

Banks have asked the RBI to extend the deadline for reserves limit by 3 months, according to a report by Reuters. Banks have warned that they could incur steep losses if they have to reduce their currency positions, totalling at least $30 billion, within the next two weeks. Banks have also requested the RBI that the new limit be only applied for net bets.

Bankers said that the extension in the limit in currency positions could allow banks to simply let their positions matured, as most of the arbitrage positions are concentrated in the 1-3 month basket, instead of rushing to unwind such trades.

The rupee has fallen over 5 per cent this year alone, and maintains its position as the worst performing Asian currency. After the announcement of limits, the rupee retraced back to settle at 94.66 against the dollar, from a record low of 94.84 per dollar in the previous session. However, as crude oil prices continue to remain elevated and the Iran war showed no further signs of de-escalation, the rupee remained under pressure.

Rupee liquidity in the banking system has grown tight due to RBI’s dollar sales to arrest currency volatility, which in turn has led to higher borrowing rates for banks. This coupled with losses on arbitrage trades could further limit flexibility for banks, and thereby put pressure on their margins.