Buy insurance for foreign currency payables

The repayment of the special FCNR deposits is now underway.

To recall, Indian rupee (INR) and our foreign exchange reserves (FX) dropped sharply from May 2013 onwards. In response, between September & November 2013, the Reserve Bank of India (RBI) offered a concessional USDINR swap window to banks, to raise fresh FCNR deposits. Prior to that, a 3-year USD FCNR deposit raised by a bank at 4% would effectively translate into INR at about 12%. With the concessional swap window and reserve exemptions, the INR equivalent cost of the same FCNR deposit now dropped to 8.5%. Banks then routed their overseas funds via their NRI clients. NRIs earned leveraged double-digit annualised USD returns, banks in India obtained relatively cheap INR funds, and the country garnered a whopping $34.3 billion across FCNR and bank overseas borrowings.

With steps taken by the RBI, the subsequent fall in commodity prices, and the decisive mandate in the 2014 parliamentary elections, rupee transformed from one of the worst performing currencies to one of the best. Our twin deficits eased, and portfolio flows poured in. RBI then mopped up USD in the forward market, in part to meet its FCNR repayment obligations. This kept USDINR forward premia levels elevated, and may have partly contributed to growth in our country's unhedged foreign currency exposures. With the repayment now in progress, RBI's outstanding gross forward purchase of USD has reduced, and 1-year forward premia continues to ease from INR 4.5 earlier to INR 3.5 now.

The repayment of the FCNR deposits poses frictional challenges – compounded by the considerable amount of confusing commentary around this. For one, a significant chunk of bank deposits is maturing together. Second, to the extent the RBI provides USD for the FCNR repayment from its FX reserves, INR liquidity would reduce. Third, as the RBI takes delivery of its USD purchased in the forward market, there could be a temporary mismatch of USD in the market, leading the banks to borrow (not buy) short-term USD. It is to RBI's credit that all these are non-issues so far – it is calibrating USD & INR liquidity very proactively.

However, the overall market context does warrant caution. USD has strengthened considerably against major currencies, and the INR is now 15% overvalued in REER terms. As mentioned the previous week, there is no shortage of external risks. One would be well-advised to take advantage of falling USDINR forward premia, to buy insurance for their foreign currency payables.
The writer is regional head of financial markets for Asean & South Asia of Standard Chartered