It is becoming more expensive for banks to hedge interest payments on non-resident foreign currency deposits (FCNR(B)) because the Reserve Bank of India (RBI) has introduced a requirement to reserve 20 percent of exposure under its Foreign Exchange Risk Reserve (FERR) framework.
Furthermore, premiums on dollar-to-rupee forward contracts have risen. For October, the premium on a 12-month contract increased by 102 basis points, reaching 4.38 percent on Thursday compared to 3.36 percent at the end of September, which increases the cost of hedging future dollar payments.
Banks were actively attracting FCNR(B) deposits through a special RBI swap window. The inflow of funds exceeded expectations, reaching $133 billion against an initial estimate of $75–$100 billion, prompting the RBI to close this window a month earlier than planned, on August 31. However, the swap window only covers the principal amount of these deposits, leaving banks with the task of arranging the hedging of the interest payments themselves.
Financial institutions are assessing optimal ways to hedge the interest component of their dollar risk on FCNR(B). Some have used forward contracts and other derivative transactions, while others have not fully hedged their risks. Banks may choose to retain some unhedged positions if they expect the rupee to remain at the current level, although their decisions will depend on currency forecasts. One senior official from a public sector bank noted that 'banks with a strong international presence may have more chances, but no one wants to hold such a large unhedged position.'
FERR Mechanism and New Requirements
The RBI introduced FERR to curb rupee volatility. Under this system, the reserve is equivalent to 20 percent of the rupee value of the nominal amount of relevant foreign exchange derivative contracts. This rule applies to certain rupee-linked contracts where users acquire foreign currency to hedge current account operations, and the notional value exceeds $2 million. Banks are also required to maintain this reserve for contracts entered into to hedge currency risks on their own assets and liabilities.
According to the revised rules, transactions made from October 12 onwards fall under the new guidelines, regardless of whether they are new contracts or extensions of existing ones. The RBI has also restricted the ability to re-book cancelled foreign exchange derivative contracts.
This reserve increases hedging costs because the funds placed with the RBI do not earn interest. Banks must maintain this reserve daily for each corresponding transaction and keep it until the day after the derivative contract expires.
The rise in forward contract premiums occurs as banks and clients adjust their positions in line with the new regulations. Market participants predict a long-term weakening of the rupee despite recent recovery, prompting importers to use current rates to lock in future dollar purchases.
One senior banker from a private bank commented: 'This is a problem that banks are trying to solve. Some large banks with natural hedging went very aggressively to attract deposits, but others, like us, did not. A lot depends on the movement of the rupee.'
Banks advise some clients to enter into shorter-term forward contracts—two to three months—instead of hedging the entire volume over longer periods. This approach reflects market participants' hopes for stabilization of market conditions and a possible review of restrictions in the coming months, though there is no certainty that the RBI will repeal these measures.