Rupee relief, higher hedging costs: What RBI’s new forex rules mean

The RBI announced tighter rules for rupee-linked foreign-exchange derivatives on October 10. The changes target transactions that can increase speculative dollar demand or weaken market discipline. They cover authorised dealers, users of derivatives, and recognised stock exchanges.

Authorised dealers can no longer let users rebook cancelled rupee-linked derivative contracts. Rollovers at maturity remain allowed under existing regulations. The RBI also reduced the threshold for transactions without proving an underlying exposure from $100 million to $5 million. In addition, banks must hold a Foreign Exchange Risk Reserve for certain larger contracts.

The reserve equals 20% of the rupee value of each contract above $2 million when it hedges current-account exposure involving a foreign-currency purchase against the rupee. The RBI said the package aims to improve risk management and keep the foreign-exchange market orderly and transparent. Banks expect some hedging to become more expensive.

A foreign-exchange derivative is a financial contract linked to the value of one currency against another. Businesses use it to plan costs or revenues when exchange rates may change before a payment is made. The article discusses derivatives linked to the rupee and foreign currencies.

For example, an importer expecting to pay dollars later can arrange a contract that fixes, or partly fixes, the rupee cost of those dollars. If the rupee weakens before payment, the hedge can offset some of the higher purchase cost. An exporter can similarly protect the rupee value of foreign-currency earnings. The article focuses mainly on importers and their dollar demand.

Hedging reduces uncertainty, but it can carry a cost. Under the RBI’s new rules, some contracts must attract a cash reserve, making hedging more expensive. That may cause businesses to reduce, delay, or reconsider some protection, especially when the extra cost outweighs the perceived currency risk.

The new limits make a much larger share of derivative activity subject to tighter discipline. The RBI reduced the threshold for undertaking foreign-exchange derivatives without establishing an underlying exposure from $100 million to $5 million. The revised limit applies across authorised dealers and recognised stock exchanges.

The RBI also created the Foreign Exchange Risk Reserve, or FERR. For each rupee-linked derivative contract exceeding $2 million, an authorised dealer must keep cash with the central bank equal to 20% of the contract’s rupee-equivalent notional value. This applies when the contract hedges current-account exposure involving the purchase of foreign currency against the rupee.

These figures do not mean every contract above $2 million automatically faces the reserve. The article specifies the current-account hedging condition. The practical effect is higher funding and hedging costs for affected users. Kotak estimated costs could rise 1% to 1.6%, while IDFC FIRST expected about 1.5%.

Importers and oil companies often hedge by arranging future dollar purchases. The hedge protects them from a weaker rupee, but it also has a price. If the RBI’s reserve requirement raises that cost by 1% to 1.6%, some companies may decide that certain hedges are too expensive or unnecessary.

That change can reduce forward and related spot-market demand for dollars. Fewer advance dollar purchases mean less immediate pressure on the rupee. Kotak Mahindra Bank said the immediate reaction could be favourable and that USD/INR could move below 95. It also expected forward premiums to soften as oil marketing companies and other importers reduced hedging.

The benefit is not guaranteed or permanent. IDFC FIRST Bank warned that elevated crude-oil prices, foreign portfolio outflows, and weak underlying capital flows could continue weighing on the currency. The banks therefore see a potentially helpful near-term effect, while global conditions and balance-of-payments dynamics remain important for the medium term.

A forward premium is the difference between a currency’s agreed future exchange rate and its current exchange rate, expressed as an added cost or return for buying currency later. It reflects market pricing for future delivery. In this case, the focus is on the premium attached to forward dollars against the rupee.

Importers and oil marketing companies use forward contracts to secure dollars for future payments. If the RBI’s reserve rule raises hedging costs, some may hedge less. That reduces their demand for forward dollars. With fewer buyers seeking future-dollar contracts, the price of that protection can ease, causing forward premiums to soften.

Kotak Mahindra Bank specifically expected forward premiums to decline as oil marketing companies and other importers reduced hedging. IDFC FIRST Bank also expected lower USD/INR rates and forward premiums in the near term. However, these effects depend on broader currency conditions, including crude prices, foreign investment flows, and balance-of-payments pressures.

A reserve requirement absorbs bank funds that could otherwise support lending or market transactions. Under the new FERR, authorised dealers must place cash with the RBI equal to 20% of the rupee value of specified derivative contracts above $2 million. If the reserve remains in place, that cash is unavailable to circulate through the banking system.

This is separate from, but connected with, other liquidity-draining measures. The RBI raised banks’ daily CRR maintenance requirement to 99% from 90%. It also announced open-market sales of government securities worth Rs 25,000 crore for October. Bond sales collect money from buyers, while the CRR keeps more bank deposits with the central bank.

Banks expect the combined effect to reduce surplus liquidity. Kotak estimated the foreign-exchange measures could withdraw around Rs 1.5 lakh crore of durable liquidity if maintained for another month. IDFC FIRST projected core liquidity surplus could fall to about Rs 2 lakh crore by March 2027 from Rs 10.4 lakh crore on October 2.

The RBI rules may influence the rupee quickly, but longer-term value depends on broader economic and financial forces. The article highlights crude-oil prices, foreign portfolio investment, underlying capital flows, interest rates, and the balance of payments. These factors shape how many dollars enter or leave the market and how much pressure falls on the rupee.

High crude prices can increase foreign-currency needs, while portfolio outflows reduce dollar supply. Weak capital flows can add to that pressure. Interest-rate decisions also matter because the RBI may adjust its policy response if the new measures reduce speculative demand and change hedging behaviour. IDFC FIRST expects a terminal repo rate of 6% to 6.25%.

The banks therefore separate the near term from the medium term. Kotak and IDFC FIRST expect lower USD/INR and softer forward premiums initially. But IDFC FIRST says global conditions and balance-of-payments dynamics will determine the currency’s medium-term trajectory. Further RBI intervention and liquidity operations may also influence conditions.