RBI's $100-Billion Dollar Bet Now Needs Unwinding

Synopsis

The Reserve Bank of India is now faced with the tricky problem of unwinding its heavily built up short dollar forward position after two years of building up a record short rupee position. But the unwind could fuel more volatility as the currency continues to lose ground for a ninth year in a row amid renewed Middle East tensions and hawkish global rate expectations, economists warn.

A Protection Mechanism Becomes an Obstacle

India's central bank has over the last two years made one of the largest dollar wagers in the world in order to prop up its already underperforming rupee, but will now have to manage its way off that bet without causing any major volatility in the currency market. Bloomberg calculations using RBI data have the book now to a record $106.7 billion in May.

A short dollar forward position, in effect, means that you have agreed to sell dollars and buy rupees at a future date, thus relieving immediate pressure without using up reserves, but marking the future due date.

The Balancing Act

The central bank has begun unwinding this position in a series of steps it expects will draw in new foreign funds, but balancing the two is tricky — too long and it remains a high cost position, while too early and it may risk the return of the new capital.

In simple terms, the underlying mechanism is that the RBI is effectively lending the dollars at a high interest rate over a period of 3-5 years through a subsidised swap window, and could incur mark-to-market losses if the rupee falls even more over the next 3-5 years, according to one economist.

Scale Without Precedent

This is an unusual rate of build-up, according to independent analysts. The RBI's forward book has expanded at a "remarkable" speed, much faster than the pace of other emerging market central banks, which are known for their proactive intervention, noted Indira Gandhi Institute of Development Research associate professor Rajeswari Sengupta.

She warned: "a large net short forward position is an unwinding of the demand for dollars, and, at some point, the RBI must buy dollars to pay back the forward book; it would not be possible for it to roll over for eternity.

The outlook for currency remains fragile

There is little sign of relief for the remainder of the year, according to forecasters: BofA Global Research projects a rupee of 98 per dollar by the end of 2026 as it anticipates three rate hikes of a total 75 basis points from the US Fed. The currency is also the worst performer in Asia this year after Indonesia's rupiah, which has fallen by almost 6 per cent, is set to lose for an unprecedented 9 consecutive years.

Soon $29 billion of the forward book was due within three months and about $51 billion was due shortly thereafter, putting the burden on the shoulders of policymakers. India's central bank is about to face a $100 billion forward book challenge on rupees.

Regional Context

The RBI is not the only central bank in the world that is taking such a drastic approach to exchange rates with derivatives; central banks in Indonesia, Malaysia and elsewhere have also used derivatives to control exchange rates, albeit to a lesser degree than the RBI has done in this cycle.