Stabilising the rupee: RBI measures may buy more time but more structural steps required

The rupee surged on Monday morning, opening 97 paise higher at 95.76 against the US dollar, as the Reserve Bank of India stepped up its efforts to lift the currency over the weekend.

The rupee may get a near-term boost, but, despite the measures, medium-term pressure on the rupee may still remain, amid continued geopolitical tensions that have driven up oil prices, foreign investor outflows, and high global bond yields, and more durable and broader policy measures may be required, analysts warn.

In the recent days, despite the Reserve Bank raising the repo rate by 25 basis points, and accumulating around $143 billion in US dollar inflows via special concessional swap window for foreign currency non-resident bank (FCNR (B)) deposits, external commercial borrowings (ECB) and overseas foreign currency borrowings (OFCB) as of September-end, the rupee has again been under pressure. On Friday, October 9, the rupee had closed at around 96.72 against the greenback. It had touched a record low of 96.96 against the dollar in May.

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The fresh steps RBI announced to shore up the rupee include special window for oil marketing companies’ dollar demands, restrictions on forex derivative contracts, introduction of a foreign exchange risk reserve (FERR) and reduction in the threshold for undertaking foreign exchange derivative transactions without establishing underlying exposure.

These steps should ideally boost the rupee. For instance, the special window for OMCs, where by RBI will undertake dollar sales to public sector oil marketing companies through designated banks effective October 12, should reroute around $11-12 billion of monthly dollar demand from the spot market to the RBI, analysts say.

The existing threshold of $100 million equivalent for undertaking foreign exchange derivative transactions to hedge contracted exposures without establishing the existence of the underlying exposure has been reduced to $5 million equivalent, across all authorised dealers.

Separately, under the new FERR requirement, for contracts exceeding $2 million, authorised dealers must maintain a 20% rupee-equivalent reserve with the RBI. This, pointed Madhavi Arora, lead economist at Emkay Global Financial Services, raises hedging costs for importers and discourages excessive derivative positioning, especially as banks are likely to pass on the additional cost, implying an additional hedge cost increase of 1.3-1.5%. Lower hedging demand could support the rupee and ease forward premiums, she pointed.

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As such the additional measures announced by RBI are expected to curb speculation in the market.

"Most measures are to check and come down heavily on speculative activity. Hence, lowering of limits (for forex derivative transactions) for no underlying exposure, or not allowing booking of cancelled derivative contracts are measures which check speculation. Once OMCs buy directly from RBI demand in market comes down. This helps stabilize rupee," explained Madan Sabnavis, chief economist at Bank of Baroda.

However, there are still things that are not under RBI's control. Foreign portfolio investors continue to sell massively from India's equity market. In fact FII selling has only increased in recent days amid surging bond yields in global markets. In the current month up to October 9, FPIs had pulled out Rs 44,166 crore, significantly more than the Rs 35,861 crore they withdrew over the entire month of September, according to data from NSDL.

The 10-year US treasury yield has been trading over 5%, and the 30-year treasury yield has been over 5.6%. In such a scenario, foreign investors may simply park their money there, instead of chasing emerging market equities in the near-term.

The RBI did raise its repo rate by 25 bps last week, but economists say more may be needed in coming months.

"Our real rates (current interest rate minus inflation) are too low, and we are not seen as an AI play," Prasanna Tantri, associate-professor, finance, Indian School of Business, told Business Today.

Several economists expect another 50-75 bps of interest rate hikes in the next few months.

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Sonal Varma, chief economist India and Asia (ex-Japan) at Nomura noted that the latest RBI measures aim to prevent speculative activity, but they are also likely to increase hedging costs and could dent liquidity in forex markets.

"That said, they are a clear signal of policymakers’ discomfort over any further rupee depreciation," she said.

Varma says, the success of the latest measures will depend on global conditions.

"If these do not improve, then more difficult policy choices will need to be made, and a broader policy toolkit – encompassing currency flexibility, fiscal-liquidity-monetary policies and structural reforms – will need to be activated," she stressed.

Emkay's Arora echoes similar sentiments.

"The measures may buy some time and provide near-term relief, but their effectiveness will remain limited unless underlying vulnerabilities are addressed. If global conditions do not improve, policy trade-offs could become expensive and would require a broader set of policy rehauls," Arora said.

The RBI has been stepping in regularly to stem the rupee decline, with the record FCNR (B) haul providing it the fire power. However, that has already reduced forex reserves by over $50 billion in just a month.

The RBI intervention may moderate the pace rather than reversing the underlying trend, according to Arora.

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"A durable solution requires greater exchange-rate flexibility, allowing the rupee to adjust gradually rather than through episodic corrections. It also requires building reserves through stable, durable capital inflows rather than borrowed deposits, alongside reducing dependence on imported oil," she noted.

Dhananjay Sinha, CEO and co-head of equities at Systematix Group, also feels the new controls may curb speculation temporarily, but they do not resolve India’s underlying external imbalance.

“Unless private investment, manufacturing competitiveness and the quality of capital inflows improve, foreign-investor confidence is likely to remain fragile. The RBI has returned to the barricades; the test is whether this buys time for structural repair—or merely delays the next test of the rupee,” he said.