Indian banks could face a rise in dollar demand as foreign-currency deposits raised under the Reserve Bank of India’s special swap window approach maturity, with the key risk centred not on the USD 127 billion principal but on the interest obligations attached to these deposits. While the RBI’s swap arrangement protects banks against principal-related currency exposure, a sharp rupee depreciation could increase the cost of meeting dollar interest payments, particularly for lenders that have left part of this exposure unhedged.
The issue becomes more relevant if the rupee comes under sustained pressure when banks need to make these payments. A weaker rupee would mean banks need more rupees to purchase the dollars required for settling the interest obligation, potentially affecting their profitability.
“If the Indian rupee weakens significantly by the time these deposits mature, banks will need more rupees than they planned just to buy the dollars needed for the interest,” said Pundri Kaksha, Vice President, Alankit Forex.
Dollar Demand Could Build Up
FCNR(B) deposits generally have maturities of three to five years, which means the associated interest payments will come due as these deposits mature. Banks have the option of hedging this future exposure, but doing so involves a cost.
According to Kaksha, fully hedging the interest exposure can cost around 3 per cent annually. Some banks, particularly public sector banks and certain private lenders, have therefore chosen to carry part of the exposure rather than pay the additional cost of hedging.
The decision may become more consequential if currency conditions change sharply. Banks that have kept their interest exposure open could eventually need to enter the market to buy dollars or put hedges in place.
“If the rupee is already sliding, the banks will be forced to jump into the market to buy billions of dollars at the exact same time the currency is struggling,” Kaksha said.
Such buying could add to demand for dollars in the spot market. The impact would depend on the size and timing of these transactions and the broader market conditions at the time.
The pressure could be more visible if banks’ dollar requirements coincide with other sources of demand, including higher crude oil payments, foreign portfolio outflows or a stronger US dollar.
USD 127 Billion Is Not Entirely Unhedged
However, the USD 127 billion figure does not represent the amount of principal sitting unhedged on bank balance sheets.
Paramdeep Singh, Founder, Long Tail Ventures, said the headline figure could overstate the actual currency risk because the RBI swap protects the principal. The more relevant exposure is the future dollar interest obligation.
“I think the USD 127 billion number makes the risk look larger than it actually is. Banks are not sitting on that amount of unhedged principal exposure. The RBI swap protects the principal; the more relevant open position is the future dollar interest obligation,” Singh said.
This makes the timing of hedging an important consideration. Banks that have chosen to leave the interest exposure open may not need to act immediately, but their requirements could become concentrated as maturity dates approach.
Singh said the greater concern would arise if several banks moved to hedge their positions or buy dollars at the same time.
“The real risk emerges if banks all decide to hedge at the same time,” he said.
Timing Could Matter For The Rupee
This concentration could matter particularly during periods when the foreign-exchange market is already under pressure. If banks enter the market for dollars alongside importers, investors and other participants, the additional demand could add to existing currency pressures.
The impact would also depend on how banks manage their positions ahead of maturity. Staggering hedges and dollar purchases could help prevent a large amount of demand from entering the market at the same time.
For banks, the trade-off is between the cost of hedging today and the possibility of having to purchase dollars at a less favourable exchange rate later.
Forex Reserves Offer A Buffer
There is, however, an important counterweight to the future dollar requirement. The foreign-currency inflows have also contributed to India’s foreign-exchange reserves, giving the RBI a larger buffer to manage periods of volatility.
Singh said the exposure should be viewed more as a timing and concentration risk than as a structural threat to the rupee. The reserves provide the central bank with greater room to intervene if market conditions become disorderly.
The situation could become more challenging if a sharp rupee depreciation coincides with tight dollar liquidity. In such a scenario, banks could face higher costs when meeting their interest obligations while also competing for dollars in the market.
A gradual movement in the currency, on the other hand, would give banks more time to adjust their positions and manage their foreign-exchange requirements.
Banks Face A Hedging Trade-Off
As these deposits move closer to maturity, treasury teams may need to monitor currency movements, maturity schedules and dollar liquidity more closely. Banks could also consider staggered hedging and maintaining adequate dollar liquidity to avoid having large requirements concentrated around the same period.
The key issue, therefore, is not the size of the USD 127 billion deposit pool alone, but how banks manage the future interest payments and whether their dollar requirements become concentrated during periods of currency stress.
