RBI policy, FX spot to affect exposures in India

Three weeks ago, this column suggested that unhedged foreign exchange (FX) liability exposures in India had increased dramatically during fiscal year (FY) 2015, by an estimated US$ 91.7 billion.

An oft repeated reason for this is widespread complacency. This manifests itself as exporters increasing hedge ratios, importers doing the reverse, and borrowers and foreign portfolio investors (FPI) leaving FX risk unhedged. The Reserve Bank of India (RBI) often warns participants against this hubris.

Besides complacency, there are two important and interconnected factors that come into play. One is the level of volatility in the currency market, and the other is the level of FX/ INR forward premia.

During FY2015, USD/INR spot started at 60.00, went down to a low of 58.50 after the 2014 election results, and finally ended the year at 62.50, a net change of Rs 2.50 since the start of the year. The one-year USD/INR forward premia, during the same period, was relatively high, at an average of about Rs 4.50, or over 7.2%. Relative to the perceived level of volatility in the FX market, the premia to be paid to hedge FX liabilities, was perceived to be high, contributing to the rise in unhedged FX exposures.

Why was forward premia high during this period? One reason was the high interest-rate differential between the rupee and US dollar. The second bigger reason was consistent purchase of forward US dollar by the RBI. During FY2015, RBI absorbed robust foreign direct investment (FDI) and FPI inflows in the spot market, which released rupee liquidity into the system. Since RBI followed a policy of keeping rupee liquidity short, this surplus liquidity had to be mopped up. Rather than using bond open-market operations, RBI chose to sell back US dollar in the spot market and purchase it in the forward market instead. Thus, during FY2015, RBI net purchased US$ 39.4 billion in the forward market, which in turn, kept USD/INR premia elevated.

Today, compared to FY2015, the level of outstanding RBI forward purchase of US dollar has reduced. Interest-rates differentials between US and India are lower as well. Thus, one-year USD/INR forward premia is much lower at Rs 3.00. This should foster FX hedging, provided USD/INR shows some level of volatility. If the RBI was to intervene in the markets to douse volatility, that risks increasing system complacency.

In summary, monetary policy, liquidity policy and FX spot and forward intervention policy, all have a bearing on FX exposures in the country.

The writer is regional head of financial markets for Asean and South Asia of Standard Chartered