How RBI's currency operations are spiking forward premia across tenures

From about 3.5 per cent at the start of December to 6 per cent now, three-month forwards rates are most affected

Forward rates in the currency markets have risen sharply across tenures as the Reserve Bank of India (RBI) is understood to have increased its intervention in the future and forward segment.  

From about 3.5 per cent at the start of December to 6 per cent now, the three-month forwards rates are the most affected. Similar trends can be seen in 6-month and one-year forward points as well. Even the five-year segment has shown a jump. 

The rise in premium has happened because of two reasons, explains Samir Lodha, managing director and CEO of QuantArt Market, a treasury solution firm: With rapid inflows into Indian market from developed economies, RBI is forced to intervene and accumulate reserves. If the RBI intervenes too much in the spot market, or buys too many dollars, an equivalent amount of rupee liquidity has to be released. The central bank has already spiked liquidity by doing such direct intervention. Rather, to neutralise any additional liquidity, the RBI is intervening in the forwards markets through swaps.  

Besides, Indian banks, in their quest for finding rupee liquidity at the financial year end are also entering into swaps to generate rupee liquidity.  

Here’s how the swaps work, illustrated in oversimplified manner:  

Let's assume the RBI has to mop up $100 from the markets without disturbing the liquidity. It will buy in the spot market, which works on a t+2 routine. Before the two days end, at which the central bank has to book the dollars in its own books, the RBI sells the dollar to a bank. The idea is that three months down the line, RBI will take the dollar back from the bank. The bank, in turn, charges a premium to RBI for committing to deliver the dollar at a future date in an uncertain environment. This premium is called forwards premium. This kind of swap is called a sell/buy swap where the RBI is selling the dollars now to buy it back at a future date and paying a premium.  

Another way RBI could intervene through the forwards market is that instead of buying dollars in the spot market, the RBI can simply go ahead and buy dollars in the forwards market and pay a premium now to the same bank along with an equivalent amount of dollars from the reserves. Though, in practice, the premium is the only instrument that gets traded in the process.  

Foreign exchange dealers say the second method is what is getting pursued now. Though, it won’t be immediately evident as the RBI data comes with two months lag. This kind of operation prevents generating excess liquidity in the spot market, and at the same time, mops up whatever dollar may come at a future date.  

Unrelated to this, but purely because of a bank’s own need to generate rupee liquidity during the year end, the bank may sell dollars now to another counterpart, and pay a premium. By selling the dollars, the bank gets immediate rupee liquidity now, and gets the dollars back at a future date.  

All of these combined, the forward premia rise.  

“It is a necessity for emerging market economies including India to intervene so that when foreign liquidity dries out and outflows happen, they can contain the volatility. Foreign exchange management is a balancing act to ensure rupee moves in a narrower band,” Lodha said. 

Interesting to note here is that the RBI is now actively managing both the bond yields, as well as exchange rates, even as both are not what the central bank professes to do. 

“RBI is signaling the market that the intervention in the foreign exchange and bond shall remain an integral part of the policy in order to manage the rupee liquidity as well as anchor the rising yields to keep the borrowing costs lower for the government," said Amit Pabari, managing director at CR Forex Advisors. 

The rise in forward premia has interesting implications for the hedging behavior among importers and exporters.  

Rising forward premiums often hints towards RBI curbing liquidity in the near term, which also makes hedging expensive for importers. In cases where inflows are robust, the importers get even more complacent. On the other side, exporters are compensated against an appreciating spot as they seek for selling dollars at every rise, further adding to the appreciation pressure on the local currency, Pabari explained. 

In fact, that dynamics is visible already in the markets now.  

“Importers are not buying long term and exporters selling on every uptick is keeping the dollar-rupee intraday volatility bound in a narrow range with a downside bias. This shall keep the pair in a narrow range of 72.30-72.8 levels for the next few sessions,” Pabari said. 

At the heart of everything is RBI’s multiple objectives – to manage the borrowing, and keeping liquidity comfortable with but inflation under checks.  

“The forward curve has, therefore, become a casualty on account of RBI managing multiple objectives. Elevated forwards continue to attract carry seeking inflows and it becomes a self-fulfilling prophecy," said Abhishek Goenka, managing director of IFA Global.  

Rupee closed at 72.76 a dollar on Monday, nearly a year high level, partly due to the RBI’s forward interventions.