In the past few days, local foreign exchange markets have seen a hyperactive central bank issuing detailed, multi-pronged guidelines to defend the ₹97-per-dollar level. The objective of these measures is to discourage local importer hedging and ensure that a large part of dollar demand moves out of the interbank market.

 

Locally, the ratio of exporter to importer hedging is almost 1:2.5, as importers aggressively buy dollar forward cover to protect against rupee depreciation, while exporters have been reluctant to sell dollar receivables due to expectations of continued rupee weakness. In a way, this psychology was driving the rupee to again test the ₹97-per-dollar level, even after the central bank had garnered a massive $133 billion through the foreign currency non-resident deposit scheme.

The recent measures, announced late on Friday night and supplemented on Monday, seek to reduce importer hedging demand significantly by discouraging proprietary trading activities by certain corporate treasuries.

The following two measures seek to achieve this:

1. A cancelled foreign exchange derivative contract cannot be rebooked by an authorised dealer bank. This measure has some practical issues. If an importer has taken a forward and wants to convert it into an option, or more importantly, has taken an option and wants to convert it into a forward, it becomes very difficult. This will make managing the hedge book quite challenging. Dynamic hedging will also be significantly restricted, with less flexibility in risk management.
2. The threshold has been reduced from $100 million to $5 million for undertaking foreign exchange derivative transactions to hedge contracted exposures without establishing the existence of the underlying exposure.

China’s Precedent
But the strongest measure is the introduction of the Foreign Exchange Reserve Ratio, a tool the People’s Bank of China used in the past 2015–2016 to defend the yuan when it had depreciated by 7% against the dollar and the PBOC had already lost $300 billion trying to defend the currency. When the PBOC introduced FERR, the measure was designed to make it costlier to bet on a weaker yuan through forward contracts and to break the feedback loop in which forward dollar purchases by clients forced banks to buy spot dollars. 

There were three key takeaways from its use:

1. It slowed, but did not stop, depreciation. The reserve requirement raised the carrying cost of forward dollar purchases and dampened a self-reinforcing hedging loop, but it acted on only one channel of a much broader outflow problem.
2. Its effect cannot be cleanly isolated. In 2016 it operated alongside offshore liquidity squeezes, tighter outflow scrutiny, direct intervention and a new fixing formula, so any attribution is a judgement rather than a measurement.
3. It was a bridge, not a solution. Once fundamentals and dollar momentum shifted in 2017, the PBOC reduced the ratio to zero in September 2017, after almost two years, indicating that it was always a temporary, reversible instrument.

In the PBOC’s case, it was a deposit with the central bank equal to 20% of the previous month’s forward foreign exchange sales contract value, held in yuan. It carried zero interest and a 12-month lock-up, so the cost was the return forgone by the bank on the frozen funds.

Hedging Costs
But in the measures announced Friday night locally, the central bank mandated that, for transactions with a notional value exceeding $2 million or its equivalent, authorised dealers must maintain with the Reserve Bank a cash FERR equal to 20% of the rupee equivalent of the notional amount of each transaction. This is not only operationally cumbersome to enforce, but also incentivises transactions to be split into amounts below $2 million.

From a cost perspective, assuming a daily average of $3 billion, with 70% involving contract values above $2 million and oil marketing companies accounting for around 30% of these, $42 billion is the likely monthly volume. Then, taking 20% of the contract value and assuming volumes fall by 50% as hedging costs increase by 1.3–1.5%, the total outflow from banking liquidity would be ₹400 billion per month.

Another point is how FERR affects importer behaviour. Assuming that FERR is interest-free, and assuming a cost of 150 basis points a year, or ₹0.125 per month per dollar hedged, an importer may have to pay ₹0.375 over and above the normal forward premium for a three-month hedge. With the spot rate lower since Monday’s opening, importers might shift to short-term hedging of one to three months, considering the higher cost of a one-year hedge.

Also, even if an importer buys a simple vanilla call option, where the bank’s risk requirements are different from those of a forward, the same 20% FERR requirement will apply. The guidelines do not differentiate between forwards and options. So even a plain call option, where the importer pays an upfront premium and gets protection against rupee depreciation, becomes very expensive.

Liquidity Risks
But all the above measures apply only to the current account.

The capital account has been left untouched, as flows there are fickle anyway. Interestingly, in the first set of guidelines, banks were not mentioned, but in the second set of guidelines on Monday, foreign exchange derivative contracts relating to authorised dealers’ own assets and liabilities were also brought within the purview of FERR. It seems there has been some pushback from corporate treasuries to include banks under the same guidelines.

On FCNR coupon hedging itself, market estimates suggest that most of the coupon hedging was done prior to the regulations. Assuming a 6.5% coupon and a five-year maturity, the total coupon hedging size is around $40 billion. A 20% FERR on that amount would imply another ₹800 billion liquidity drain.

The separate window for oil companies implies no additional outflow of liquidity, only the impact of the existing $10 billion monthly reduction in the RBI’s foreign exchange reserves, assuming average monthly oil imports of $15 billion and OMC demand at 60–65%.

The increase in the daily minimum cash reserve ratio might also reduce liquidity by ₹700 billion, assuming system-wide CRR balances are now at 103% of the requirement, against 94% previously.

Combining all these measures, we could see a total incremental outflow of around ₹4.0 trillion–₹4.5 trillion in the next few months. Along with the expected increase in currency in circulation of ₹2.5 trillion during the remainder of 2026–27, this might bring durable liquidity below ₹2 trillion by the end of March 2027.

The larger question now is what is motivating the central bank to engineer such a swift reversal in liquidity. Is it a precursor to increasing the marginal standing facility rate or widening the corridor?

Another question for the future is what happens in February–March 2027 when liquidity suddenly evaporates as these calculations suggest. Will we see the return of variable rate repo operations? Going from one extreme to another in a matter of months might not be conducive to macroeconomic stability.

For the time being, the rupee has weathered the storm, aided by these measures, but as long as the balance of payments and capital flows do not change, the sky is not yet clear. To find a permanent solution, either domestic rates have to rise materially to induce debt capital inflows, or equity capital inflows have to resume, aided by the much-discussed taxation changes.