PNB scam fallout: Rupee forwards crash as banks stop issuing LoUs

Nirav Modi scam has resulted in disruption in cross-border trade as banks are unwilling to provide guarantees

The upshot of banks’ reluctance to issue letters of credit, letters of undertaking (LoUs) and such guarantees affecting normal functioning of cross-border trades is that one-year rupee forward rates have crashed in the currency market as importers scampered to buy dollars in the spot market to meet their payment obligations.

The crash in the one-year forward rates, about 50 paise in a matter of a few days to as low as 239 paise, reflects the acute dollar shortage in the market. This is accompanied by a spike in spot rates and in the immediate term, typically one month or less, forward premiums. The forward premiums recovered slightly from recent lows to close at 252 paise on Wednesday. 

While the 50 paise fall does not seem much, forwards move by only a few paise every day. “This kind of fall happens only when banks stop lending, in this case issuing guarantees. For example, in the aftermath of the Lehman crisis of 2008-09, we had seen such a sharp fall,” said Jayesh Mehta, head of treasury for India at Bank of America Merrill Lynch.

More recently, the forward premiums had fallen by as much as 100 paise within three weeks after November 8, 2016. Short-term interest rates had fallen dramatically after demonetisation and there was a larger supply of dollars due to redemption of FCNR-B deposits. 

Forward premium, calculated in paise, is the additional amount over the spot rate that a buyer needs to pay to buy dollars in future. 

The strategy now, say currency dealers, seems to be to buy the dollar whenever there is a need. “Cash seems to be king now and importers will buy dollars when the need arises,” said a currency dealer who did not wish to be named. He added that keeping unhedged foreign exchange positions for the long term was not good for the economy as a whole.

When spot-dollar buying goes up, some of it is done by unwinding the long-term forward positions in favour of the short-term premium or spot rates, and this leads to a fall in the long-term forwards rate. Similarly, when demand for the dollar is low in the spot market, the short-term premium remains low, while the longer period premium goes up.

The one-year forward rates saw a sudden dip, particularly on Tuesday, with the forwards falling to 3.75 per cent, from 4.25 per cent last week. The rupee had weakened to a month’s low of 65.11 on that day.

According to Abhishek Goenka, managing director of IFA Global, long-term forward positions are being cancelled after hawkish minutes from the US Federal Reserve. The dollar is expected to strengthen going forward and thus, exporters would not like to lock themselves now into selling dollars cheap in the future. “Banks have stopped issuing LoUs and therefore the paid positions (long-term hedges) are also not being rolled over,” Goenka said.

Forward rates have been falling for a year now as portfolio flows in the local markets remained healthy in 2017. The debt segment alone received about $23 billion worth of foreign currency inflows and this kept the rupee strong and stable. This reflected favourably in the forwards market as importers steered clear of hedging. Now that the rupee is expected to weaken as the US economy recovers and the dollar is expected to rebound from its multi-year low, importers will likely crowd in at the longer end of the forward curve and the rates there will rise. Here, the central bank, with its more than $30 billion worth of forward position, could help.

Currency dealers said the Reserve Bank of India (RBI) was actively intervening in the forwards market by selling dollars there, bringing the rate lower, so that importers could buy dollars cheap for their future commitments.

“The RBI knows that the LoU crisis is not going to end quickly, but payment obligations will arise in the future. And hence, it is intervening in forwards as it cannot do much to spot rates without disturbing the market,” said the treasury head of a foreign bank.

For now, the RBI is using public sector banks (PSBs) to tide over the dollar shortage in the market. “Nationalised banks are funding the dollar shortage by doing swaps (selling spot dollars and buying forwards),” said Goenka. The forward buying of dollars on Wednesday also helped stabilise the rates, which firmed up by a paise.

The rupee closed at 64.89 to a dollar on Wednesday, up from 65.11 on Tuesday on increased dollar supply by PSBs, on behalf of the RBI.