RBI Reduces NDF Portfolio Amid Rupee Pressure

India’s central bank, the Reserve Bank of India (RBI), has begun curtailing its extensive non-deliverable forwards (NDF) portfolio, according to sources familiar with the development. This marks a shift from its previous strategy of using the NDF market to counter the strong US dollar.

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Recently, the RBI allowed certain short dollar positions in the offshore NDF market to lapse without renewing them, said the sources, who requested anonymity. These positions reportedly had maturities ranging from one to three months.

This move indicates a more strategic shift by the RBI, which had previously amassed a net short position of around $60 billion in the NDF market. However, the decision has exerted downward pressure on the rupee in the domestic market as banks settle their end of the forward trades, the sources noted.

Despite a near 2% depreciation against the dollar this year, the rupee remains relatively strong compared to other Asian currencies, retaining greater stability, as per Bloomberg data. However, it currently trades near a record low.

The decision to scale back NDF positions occurred prior to Sanjay Malhotra assuming office as the RBI Governor on December 11. Market participants are closely observing whether this leadership transition will bring about new strategies after years of interventions on both sides of the forex market.

Historically, the RBI has intervened to reduce rupee volatility, a practice criticized by the International Monetary Fund (IMF). The IMF reclassified India’s currency regime as a "stabilized arrangement" from a floating system in 2022, a decision the RBI described as subjective and beyond the IMF’s purview.

The unwinding of NDF trades has also affected the domestic rupee market. Banks that had balanced their offshore long-dollar positions by short-selling dollars onshore have been compelled to buy dollars in India to close their positions. This adjustment has created upward pressure on onshore forward implied yields. For instance, the one-month yield has surged by 72 basis points this month, marking the most significant movement in over a year, while the three-month yield has risen by 42 basis points.

The RBI has attempted to counteract dollar buying by utilizing its reserves to support the rupee onshore. However, this move has tightened rupee liquidity at a time when businesses require funds to meet tax obligations. To mitigate the liquidity crunch, the central bank has employed repo operations to inject rupee liquidity into the market. This balancing act highlights the complexities of managing currency stability while addressing liquidity needs.