The Indian rupee recorded its largest weekly gain in seven months, lifted by policy intervention, though questions remain over whether the rally can be sustained.
The rupee appreciated about 2% over the week, closing at 84.96 per dollar on Friday. After the currency had earlier approached a record low, the RBI stepped in, pushing the exchange rate toward stability by channeling oil-dollar demand to the over-the-counter market and sharply tightening foreign exchange purchase limits.
However, the side effects of these measures have also become apparent. Hedging costs have surged to a decade high, bond yields have climbed to their highest level in more than three years, and liquidity in the foreign exchange market has been shrinking rapidly.
Market participants have expressed concern about the frequent adjustments to foreign exchange rules, arguing that such moves could weaken policy predictability. Analysts noted that whether the rupee can continue to rebound depends crucially on whether deep-seated economic pressures can be effectively alleviated.
Regulatory Measures Disrupt the Hedging Market
A key measure announced by the Reserve Bank of India last Saturday requires banks to set aside provisions equivalent to 20% of the rupee value for foreign exchange derivative transactions exceeding $2 million. This directly raised the cost for companies and banks to hedge exchange rate risk through forwards, swaps, and other instruments.
Onshore dollar-rupee forward yields immediately surged. The three-month forward yield once rose to 6.54% on Thursday, setting a closing high since May 2016.
Abhishek Goenka, CEO of IFA Global, described the market as "extremely dislocated" and noted that companies currently find it cheaper to borrow rupees and convert them into dollars than to borrow dollars directly, a signal of severe market pricing distortion. He advised clients to hedge only immediate needs for now.
The RBI clarified on Thursday that the new rule applies only to transactions hedging exchange rate risk and does not cover banks' business of buying and selling currencies for clients or maintaining normal market operations. Buoyed by this, the three-month purchase cost fell back to 5.89% on Friday.
Tighter Foreign Exchange Purchase Caps Affect Companies
In tightening foreign exchange purchase restrictions, the RBI cut the cap under which foreign exchange can be purchased without providing exposure proof documents by 95%, to $5 million. This means more companies must submit additional compliance documents when buying foreign exchange, and related business processes will face higher friction costs.
Anshul Chandak, head of treasury at RBL Bank, said bank treasury departments may face shrinking client foreign exchange business and potential losses in fixed-income trading books in the fourth quarter of this year (October to December). He described the current situation as "swallowing a bitter pill for long-term gain."
The bond market is also under pressure. With high oil prices and continued foreign capital outflows, the market is betting that if exchange rate intervention alone proves insufficient, the RBI may need to rely further on interest rate hikes, pushing bond yields to their highest level in more than three years.
Fundamental data show that the external pressure facing the rupee has not receded. India's merchandise trade deficit widened to $30.21 billion in September from $26.8 billion in August, further aggravating concerns about current account pressure.
On the reserves front, the RBI raised more than $14 billion through special measures and has so far used about half of that to replenish foreign exchange reserves. However, as of the end of August, the central bank's net forward dollar liabilities still stood at $20 billion.
Policy Predictability Becomes a Key Variable
For institutional investors, policy transparency has become a core consideration in whether to maintain allocations to Indian assets.
Shamaila Khan, head of global emerging markets and Asia-Pacific fixed income at UBS Asset Management, said:
Maintaining a transparent policy framework, as well as efficient hedging and trading capabilities, is key.
She added that the measures have not yet materially changed UBS's strategic view or overall allocation to India, but higher hedging costs mean UBS will demand higher returns from Indian assets.
If liquidity remains persistently low and hedging costs stay elevated, companies and investors may demand a higher risk premium for holding rupee assets, or even reduce their willingness to increase holdings. This would leave the rupee facing greater downside risk when the RBI eventually steps back.
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