The rupee may be holding steady against the dollar so far this year, but the sharp erosion of over 10 per cent last year seems to have prompted the Reserve Bank of India to protect the Indian currency from any debilitating speculative attack emanating from overseas. The recent announcement of the RBI to allow banks located in the GIFT international financial services centre to issue rupee Non Deliverable Forward (NDF) contracts to Indian residents needs to be seen against this background.

NDFs, as their name implies, are derivative contracts which do not require delivery of the currency, with settlement taking place in cash. These contracts are traded in offshore financial centres in other countries. The rupee is one of the currencies with a vibrant offshore NDF market. Of concern is the fact that the transaction volume in the offshore rupee market is almost as large as the domestic market and the RBI has limited means to influence the currency’s movement in these markets. The RBI is now attempting to increase the number of Indians participating in the offshore rupee market so that they can counter the selling pressure from non-resident speculative traders. But the extent to which this ploy works will depend on the way the guidelines are framed. 

Studies have established that the linkage between onshore and offshore rupee market is very strong. An RBI working paper by Rajan Goyal, Rajeev Jain and Soumyasree Tewari found that the interlinkage between the onshore currency market and the Non Deliverable Forward market was bi-directional under normal conditions but in periods when the rupee comes under pressure, the linkage is unidirectional from the NDF market to the onshore market. This implies that speculative trades in the NDF market exacerbate rupee weakness in the domestic market, as was witnessed in 2013. The RBI has been looking for ways to mitigate the influence of the offshore market for a while now. In June 2020, banks in the GIFT IFSC were allowed to participate in the offshore NDF market.

The latest move could lead to a manifold rise in the number of locals participating in the NDF market since treasury departments of not just banks, but companies can also trade in the rupee NDF market now. Indian financial institutions will be more circumspect about joining a speculative attack by overseas traders in the NDF market and can support the rupee in periods of distress. But it is hoped that the central bank is not too stringent while framing guidelines on this issue. The task force on offshore rupee markets under the former RBI Deputy Governor Usha Thorat had recommended permitting residents to trade in offshore currency derivatives up to a limit of $100 million without the need for an underlying exposure. This could be considered. The other recommendation of the task force — allowing non-residents to hedge their rupee exposure in onshore market — should also be encouraged to increase the influence of the onshore market.