RBI's New Forex Reserve Rules Raise FCNR(B) Deposit Hedging Costs For Banks

Indian banks face rising costs for hedging dollar interest payments on foreign currency non-resident bank (FCNR(B)) deposits following new foreign exchange regulations introduced by the Reserve Bank of India (RBI).

Under the Foreign Exchange Risk Reserve (FERR) framework, lenders must maintain cash reserves equivalent to 20% of the rupee value of eligible foreign exchange derivative contracts.

As per a report by Business Standard, the requirement comes as dollar-rupee forward premiums have increased sharply, making currency hedging more expensive.

The 12-month dollar-rupee forward premium rose 102 basis points during October, reaching 4.38% on Thursday from 3.36% at September-end.

Banks are particularly exposed because the RBI's special swap window covers only the principal of FCNR(B) deposits, leaving interest payments to be hedged separately.

The facility attracted $133 billion in deposits, exceeding initial expectations of $75 billion to $100 billion.

Consequently, the central bank closed the window on Aug 31, a month ahead of schedule.

Some banks have hedged their interest obligations through forward contracts and derivatives, while others retain partially unhedged exposures.

Lenders with substantial overseas operations may benefit from natural hedges, although currency movements remain a significant consideration.

The FERR framework applies to specified rupee-linked derivative transactions exceeding $2 million, including eligible hedges for current account transactions and banks' own foreign currency exposures.

Contracts entered into or rolled over from Oct 12 fall under the revised requirements.

The RBI has also restricted the rebooking of cancelled foreign exchange derivative contracts.

Banks must maintain the prescribed reserve daily until one day after the relevant derivative expires.

Since these funds earn no interest, the requirement increases the effective cost of hedging.

Meanwhile, expectations of longer-term rupee depreciation have encouraged importers to secure forward dollar purchases.

Some banks are advising customers to consider shorter hedging periods of two to three months instead of locking in longer-term contracts.

Market participants hope conditions will stabilise, although there is no assurance that the RBI will relax its restrictions.