Biggest currency clampdown in a decade risks backfiring for India

By Subhadip Sircar, Bhaskar Dutta and Anup Roy

 

India’s boldest effort in a decade to support the rupee runs the risk of pushing away the global investors it’s spent years wooing.

 

As the currency hit new lows amid the Iran war, the Reserve Bank of India forced local banks to unwind bearish bets across onshore and offshore markets. The lack of an immediate explanation rattled the lenders and investors, leaving them unsure of the RBI’s intent and questioning its handling of risks, according to bankers, who asked not to be identified discussing client matters.

 

Since the curbs, the rupee has gained more than 2% to 92.59 per dollar as of Friday — but that’s come at a cost. Banks are staring at potential losses running into the hundreds of millions of dollars, according to Jefferies Financial Group Inc. Hedging costs have jumped, making it harder for investors to buy protection. Foreign investors, meanwhile, have slashed their bond holdings.

 

The tighter controls and abrupt announcement may fuel perceptions that India is backtracking on efforts to integrate with global markets. Those reforms — introduced after the 2013 taper tantrum, when the Federal Reserve’s plan to scale back bond purchases triggered outflows from emerging markets — helped boost India’s appeal and paved the way for its inclusion in JPMorgan Chase & Co.’s bond index in 2024.

 

The rupee market also expanded, with the currency gaining popularity in financial hubs such as London and Singapore. Now, it’s more widely traded overseas than in India.

 

The degree of intervention and lack of clear signaling raise concerns about policy predictability and transparency, said Sanjay Guglani, chief investment officer at Singapore-based Silverdale Capital Pte Ltd., which manages about $1.5 billion. He described the RBI’s steps as discretionary, adding that “this raises the bar for rupee assets among offshore investors.” 

 

The measures started in late March, when the RBI capped banks’ daily currency positions in local markets at $100 million by April 10, sparking a scramble to unwind at least $30 billion in arbitrage trades. 

 

When that failed to halt the rupee’s slide, the central bank extended the curbs to offshore derivatives days later, barring lenders from offering non-deliverable forwards, which allow investors to bet on the currency without holding it. Together, they amount to a coordinated push to flush out bearish rupee positions and speculative trades across the market.

 

Officials were targeting investors using NDFs to build short rupee positions, as well as banks running arbitrage trades — buying dollars onshore and selling offshore — to profit from price gaps. Together, they had amplified pressure on the rupee.

 

BofA Securities Inc. economists warned that the recent measures risk rolling back a decade of liberalization authorities have pursued to avoid a repeat of 2013. They “essentially break the link RBI had cultivated in the last decade,” the analysts led by Rahul Bajoria wrote in a note.

 

The experiences elsewhere offer a cautionary tale. China’s 2015-17 squeeze on offshore yuan liquidity stabilized the currency but triggered funding spikes and unnerved global investors. Malaysia’s 2016 clampdown on offshore ringgit trading curbed speculation while draining liquidity. In both cases, the moves carried reputational costs, underscoring the fine line India must navigate.

Regulatory Risk 

Some market participants say the sudden policy shifts are prompting them to reassess the risks of operating in the market.

 

Two senior foreign bankers said clients had questioned the RBI’s seemingly arbitrary move. They also asked: if speculative trades had become as large and destabilizing as policymakers suggest, why was it allowed to build up in the first place? The bankers asked not to be identified discussing private matters.

 

Some foreign investors said they may stay away from India even after the current uncertainties ease, the bankers added.

 

One senior executive at a European bank also said it would be difficult to return to the NDF market even after the RBI lifts restrictions because of the heightened perception of regulatory risk. Participation may take years to recover, he said, asking not to be identified as those deliberations are private.

 

As a result of the new measures, offshore 12-month forward points — a gauge of hedging costs overseas — jumped to their highest level since 2013, while the onshore costs hit the highest since 2022. Foreign investors have cut almost $1 billion from their holdings of index-eligible bonds. 

 

Prashant Singh, a senior portfolio manager for emerging-market debt at Neuberger Berman Group LLC, said India’s onshore yields are becoming more attractive, but the external environment and recent regulatory steps have added to the uncertainty and increased currency hedging costs.

 

“All of this makes taking active positions in India tricky over the near term, and we prefer to stay on the sidelines till we get more clarity,” Singh said.

 

Jefferies estimates banks could face losses of up to ₹5,000 crore ($539 million) from the forced unwinding. Bloomberg News previously reported that State Bank of India, the country’s largest lender, had about $5 billion in such positions and expects losses of around $32 million.  

 

The RBI’s urgency reflects a deteriorating external backdrop, including higher US tariffs and a spike in energy prices after the Iran war — a toxic mix for an oil-importing economy with a persistent current-account deficit. Rising crude has inflated the import bill, while a global flight to safety has boosted the dollar. A two-week US-Iran ceasefire may offer some relief.

 

RBI Governor Sanjay Malhotra said Wednesday the central bank remains committed to deepening currency markets and internationalizing the rupee, and that the latest measures don’t signal a shift in stance. In his first public remarks since the measures were introduced, he added that they’re only temporary and will not remain in place forever. 

 

The Finance Ministry has reached out to external experts for ideas to stabilize the rupee, according to a person with knowledge of the matter, who asked not to be identified to discuss confidential matters. This reflects the government’s worry that foreign institutional investors may stay on the sidelines if depreciation risks increase, the person said. 

 

An email to the Finance Ministry went unanswered, and the RBI didn’t immediately respond to a request for comment on concerns about regulatory risks among foreign investors and bankers.

RBI Intervention 

Authorities have long been cautious about opening up to the NDF market, a key channel for speculative pressure during the 2013 taper tantrum. The RBI took a big step in 2020 by allowing local banks to trade the rupee in places like London and Singapore, and later let them offer these contracts to domestic clients. It has also, at times, informally urged banks to avoid building new offshore positions, but the latest measures are the most draconian yet.

 

The RBI, too, has used the offshore market for its own intervention. Over the past few months, its forward book has widened to $78 billion in dollar liabilities as of February, some of which includes overseas bets. Those positions eventually need to be settled, creating fresh demand for dollars that can weigh on the local currency.

 

To be sure, the latest measures don’t restrict foreign investors from hedging through domestic banks, as long as it’s in the deliverable market and not for speculation. They also don’t prevent others from offshore trading of NDFs. 

 

“Such measures are likely to create a wedge between offshore and onshore markets,” said Soumya Kanti Ghosh, chief economic adviser at State Bank of India and a member of the prime minister’s economic advisory council. “This might create a vicious loop” where offshore premiums see gains, he added.

 

In recent years, regulators have repeatedly stepped in to cool market activity at a time when India is seeking a bigger place in global portfolios. A crackdown on equity derivatives tightened rules on short-term speculation by cutting the number of weekly index options expiries. Authorities stifled a once-buoyant onshore currency futures market in 2024.

What Bloomberg Strategists Say... 

While the rupee is likely to be a lot steadier in light of the ceasefire and the RBI’s previously announced measures to curb speculation against the currency, the deficit outlook will still check how far the rupee can strengthen from here.

 

— Ven Ram, Markets Live Strategist

 

Still, the trade-off between currency stability and an open market may be unavoidable in times of stress. RBI’s Malhotra said FX volatility surged in the final weeks of March, with positions building up and arbitrage widening between non-deliverable and deliverable markets. Those linkages help price discovery in normal times, but not during periods of excessive volatility.

 

Former Securities and Exchange Board of India board member Ananth Narayan said there’s been a substantial build-up of bets against the rupee over the past two years, some for hedging but others likely speculative. Excessive one-sided positioning can be destabilizing, he said, making the RBI’s pushback understandable even if the timing is debatable.

 

Some analysts say the RBI’s measures offer only limited relief for an economy facing a current-account deficit and capital outflows. High oil prices may worsen inflation and the deficit, accelerating the rupee’s decline. The currency pressure isn’t likely to dissipate soon given the war, said Rajeswari Sengupta, associate professor at Indira Gandhi Institute of Development Research in Mumbai. 

 

The policy’s effectiveness depends on what’s driving speculative bets. If trades were momentum-driven, they may unwind and help stabilize the rupee. But if they reflect deeper views about the outlook, investors may “lick their wounds and hold on,” and the fundamentals will re-assert themselves over time, said Jayanth R. Varma, a former member of the RBI Monetary Policy Committee. 

 

For now, the NDF curbs have eroded liquidity and made hedging more difficult. The widening gap between onshore and offshore markets is already weighing on foreign demand for Indian bonds and could dent further inflows.

 

“Foreign investors need a reliable and predictable investment framework to maintain or increase their portfolio allocations to India,” said Rajeev De Mello, global macro portfolio manager at Gama Asset Management SA.