Why RBI's forex cap direction has not worked to ease rupee pressure

Cap on banks' forex positions offers only short-lived relief as oil prices, capital outflows and structural imbalances continue to weigh on the rupee

The Reserve Bank of India’s (RBI’s) cap on the forex positions of banks has done little to ease the underlying pressure on the rupee with the initial boost from the decision quickly fading.

 

Market participants said the directive on net open positions might have had unintended consequences.

 

The rupee, after opening over 1 per cent stronger on Monday, reversed course to breach the 95-per-dollar mark with multiple pressures continuing to weigh on the currency.

 

On Friday, the RBI capped banks’ net open position (NOP) in the onshore forex market to $100 million, overriding the board-set internal cap of 25 per cent of capital.

 

After building up its forward books, onshore and offshore, estimated to hit around $100 billion by March, and selling over $15 billion from reserves in the first three weeks of March, the RBI has turned to additional measures to support the rupee.

 

Market participants said that while this move sharply restricted banks’ ability to hold long-dollar positions in the onshore market, it was unlikely to address the underlying pressures on the rupee.

 

“The bottom line is that the RBI’s cap does not change the underlying dynamics that fuelled pressure on the currency in the first place,” a report by Barclays said. 

 

“We note that while the RBI cap had a knee-jerk impact, initially boosting the INR, the effect is already fading quickly.  In short, the rupee remains particularly vulnerable to an oil supply shock, while India’s BoP position may deteriorate further, and capital and financial account pressures are increasing,” the report said, adding importers’ dollar buying was also expected to pick up, likely outweighing any exporter dollar selling.

 

Moreover, the RBI’s outstanding exposure on forward books adds to pressure on dollar buying.

 

The rupee remains particularly vulnerable to the oil shock, with Brent crude oil price trading at $115 per barrel, along with India’s balance-of-payments position at risk of further deterioration amid rising pressures on the capital and financial account.

 

“Despite initial strength supported by the RBI’s move to reduce banks’ overnight net open position limits, the rupee failed to hold gains and reversed sharply due to a combination of rising crude oil prices, persistent geopolitical tensions, and a strong dollar environment,” said Abhishek Goenka, founder and chief executive officer, IFA Global. 

 

The State Bank of India said in a report that the move to rationalise banks’ open positions, while well intentioned, appeared to have widened the gap between onshore and offshore markets.

 

Typically, Indian banks, public and private, run long positions in the onshore market and short positions offshore, while foreign banks tend to do the opposite. As these positions are unwinding, liquidity strains are beginning to emerge, potentially creating a feedback loop that pushes offshore premiums sharply higher.

 

“We believe the $100 mn limit should be imposed on the trading book only and not on whole bank book level as it creates operational challenges. This is also important as many FPIs (foreign portfolio investors) and some FDI players would be taking out their funds in present situation (reallocation/profit booking) and would be placing genuine demands on banks to fulfil on order matching basis,” the report said.

 

Market participants further said that a more staggered implementation might have yielded better results, making the timing of the decision somewhat surprising.

 

Banks, however, were able to shift part of their exposures to corporate and unwind positions in a calibrated manner, limiting losses on their books.

 

Market participants do not rule out further action by the RBI after its latest move, the first since 2011 to explicitly set a limit on the net open position.