Why dollar forwards are gaining popularity at the RBI

How does the RBI intervene to defend the rupee when it is crashing? For a long time, the only strategy was to sell dollars. In the last few years, the RBI is increasingly relying on rupee forwards to defend the rupee. Here is why.

The forward advantage

In the month of September, the RBI has been actively involved in defending the rupee. It first tried to defend the rupee at 70, then at 72 and now is defending the rupee at around the 74 mark. RBI cannot afford to let the rupee weaken too much as it has implications for the import bill and for the FPI flows. During the month of September, the RBI sold spot dollars worth $2.3 billion. During the same period, the RBI sold dollar forwards to the tune of over $5 billion. This shift to the forward market began under Dr. Rajan but it has continued as a conscious strategy of the RBI. What has triggered this strategy shift?

Forwards over spot dollars

There are 3 broad reasons why the RBI is relying more on forward dollar selling these days. Firstly, the RBI forex chest as shown in the chart above is now below $400 billion. That is less than 9 months of imports and this puts India at a disadvantage on sovereign ratings vis-à-vis BRICS nations. Secondly, there is a liquidity implication to using the spot market route. When the RBI sells dollars in the spot market, it ends up absorbing domestic rupee liquidity from the market. In months like September, when domestic liquidity was under strain, this spot selling of dollars would have only worsened the situation. Thirdly, selling dollar forwards allows the RBI to create a ladder strategy. More importantly, the RBI is able to use the forward market to give signals on the likely movement of the rupee. For now it looks like this strategy shift by the RBI is here to stay!