FCNR(B) interest bill to keep dollar hedging costs high

The RBI's special hedging window covers the foreign-currency deposits raised by banks, but not the interest owed on those deposits. Banks therefore remain exposed to exchange-rate movements on every future interest payment. That exposure matters because the rupee value of those payments can rise if the dollar becomes more expensive.

To manage the risk, banks buy dollars forward. But banks across the system are seeking dollars for the same purpose, and there are not enough natural sellers. This pushes up the forward premium, which is the extra price for locking in future dollars. FERR adds another cost because banks must hold cash equal to 20% of eligible derivative contracts' rupee value.

Many banks are avoiding a full, long-term hedge and instead use short-term contracts that are rolled over. This reduces the immediate commitment but brings banks back to the market repeatedly as interest accrues. That continuing demand can keep hedging costs high, although costs may fall when the rupee strengthens or forward premia ease.

FCNR(B) means Foreign Currency Non-Resident (Bank) deposits. They are bank deposits held by non-residents and denominated in a foreign currency rather than rupees. The deposits give banks access to foreign-currency funds, but they also create an obligation: banks must return the deposit and pay the agreed interest in that currency.

That obligation becomes a dollar liability when the relevant currency is dollars. Indian banks may earn or hold rupee assets, so they need protection against a change in the rupee-dollar exchange rate. They can buy dollars forward to lock in the rupee cost of future interest payments. The article specifically notes that the RBI's hedging facility did not cover interest on these deposits.

As interest accrues, banks must manage the growing exposure. Many are using short-term forward contracts and rolling them over instead of hedging the full future obligation upfront. This approach keeps the exposure manageable for now, but it also creates recurring demand for dollars in the forward market.

The special foreign-currency deposit programme raised $133 billion, with deposits arranged for three to five years. This is a large exposure for the banking system because banks must manage the currency value of their future obligations. The size and maturity of the programme make its hedging structure important for dollar demand.

The RBI provided a hedging facility for the $133 billion raised under the special window. However, the facility does not cover interest payments to non-resident depositors. Banks must therefore arrange their own dollar hedges for that interest, year after year, in the open market. The uncovered amount is the interest obligation, not the $133 billion deposit principal described in the article.

This distinction is driving continued demand for forward dollars. Many banks are using short-term contracts that can be rolled over as interest liabilities accrue. FERR has made longer-tenure hedging more expensive, while foreign banks may be more comfortable carrying some unhedged positions because clients provide them with a steady stream of dollars.

A forward premium is the additional price paid today to lock in dollars for delivery at a later date. It reflects the cost of securing a future exchange rate instead of buying dollars immediately. For banks, it is part of the expense of protecting rupee funds from a more costly dollar later.

The premium rises when demand for forward dollars overwhelms supply. In this case, many banks are buying dollars forward to cover interest owed on FCNR(B) deposits. The article says there are not enough natural sellers for all that demand. Sellers can therefore command a higher price, lifting the premium across the market.

The move was sharp but uneven over time. One-month forward premia rose from 2.50% in early August to 8.50% by mid-October, while one-year premia rose from 2.78% to 4.85%. By November 6, they eased to 3.83% and 3.91%, respectively, still reflecting near-term dollar demand.

The foreign exchange risk reserve, or FERR, is a new reserve requirement for banks' derivative positions. Introduced on October 10, it requires banks to maintain cash equal to 20% of the rupee value of eligible foreign-exchange derivative contracts. The rule therefore adds a funding burden to certain hedges.

A bank arranging a dollar-forward contract must now set aside cash against that position. That cash cannot be used as freely elsewhere, so the hedge becomes more expensive. Banks may pass some of the extra cost to customers. When banks also compete for forward dollars, the added expense can put further pressure on forward premia.

FERR has made banks more cautious about locking in dollar liabilities for long periods. One treasury head said many banks were still assessing their strategy. Instead of hedging the entire interest obligation upfront, they are using shorter contracts and rolling them over as liabilities accrue. This limits long commitments but sustains market demand.

Many Indian banks have not yet established a complete hedging strategy for FCNR(B) interest exposure. They are still assessing how to manage the obligation, while FERR has added a new cost to derivative positions. Locking in dollars for several years now requires cash to be reserved against eligible contracts.

Instead of hedging the entire future interest obligation at once, banks use short-term forward contracts. As interest liabilities accrue, they buy protection for shorter periods and then roll those contracts over. This spreads the decisions over time and avoids committing immediately to a costly long-tenure hedge. It does not remove the underlying exposure.

The trade-off is repeated market participation. Banks must return to the forward market whenever more interest becomes payable, sustaining dollar demand. The article says foreign banks are more comfortable carrying unhedged positions because clients provide steady dollar inflows. Some midsize banks hedged most of their exposure once costs fell within internal thresholds.

A currency hedge protects a bank by fixing, or partly fixing, the exchange rate for a future payment. If the rupee weakens before the payment date, the bank is less exposed to a higher rupee cost for those dollars. A forward contract is one way to arrange that protection, although the article focuses on its cost rather than detailing its settlement.

Banks need dollars because FCNR(B) deposits are foreign-currency obligations owed to non-resident depositors. The article states that interest on these deposits is not covered by the RBI's hedging window. Banks must therefore buy dollars forward themselves, year after year, to meet the interest obligation. That creates continuing demand in the forward market.

The protection is not free. Limited natural sellers, strong system-wide demand, and FERR's cash requirement raise the cost of hedging. For now, many banks use short-term contracts and roll them over as interest accrues. Foreign banks may carry more unhedged exposure because clients supply a steady stream of dollars.