FCNR(B) interest bill to keep dollar hedging costs high

Mumbai: Multibillion-dollar FCNR(B) interest bills, combined with the Reserve Bank of India's fresh reserve requirement on forex derivatives, are expected to maintain high dollar hedging costs for Indian banks, according to treasury executives. While the RBI offered a hedging facility for the $133 billion raised over three to five years under its special window for foreign currency deposits, banks bear the currency risk on interest payments to non-resident depositors.

With an average interest rate of 6.5-7.0%, annual interest outgo on these deposits is projected at $8.6 billion to $9.3 billion. Approximately half of this amount remains unhedged, leaving lenders with over $4 billion in annual dollar exposure. Anindya Banerjee, Kotak Securities' head of currency research, explained that banks must buy dollars forward themselves yearly due to the interest on FCNR(B) deposits not being covered by the window.

Forward premiums arise when the banking system collectively buys dollars forward for the same reason, with no natural sellers, causing the extra price to rise. The RBI's new reserve requirement, introduced on October 10, mandates banks to hold a cash reserve equivalent to 20% of the rupee value of eligible foreign-exchange derivative contracts, making it more expensive to offer dollar forwards.

Forward premia surged from 2.50% and 2.78% for one-month and one-year horizons in early August to 8.50% and 4.85% by mid-October before easing slightly by November 6. Treasury heads reported that most banks have not established hedging strategies as they assess the best way to manage this exposure. Some banks manage the exposure as it accrues using short-term contracts that can be rolled over instead of hedging the entire interest obligation upfront.