Indian Banks Leave Sizeable FX Risk Open on Overseas Deposits, Creating Potential Rupee Overhang

Indian banks have left a large share of the future interest payments on their overseas foreign-currency deposits unhedged. That creates a pool of latent dollar demand which could add to depreciation pressure if the rupee starts to weaken, according to five bankers familiar with the positions.

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Lenders have raised more than $127 billion through these deposits since the central bank introduced them in June as part of a set of one-off measures to shore up India's balance of payments against surging oil prices. 

The Reserve Bank of India's special swap facility protects banks from currency risk on the principal. Interest payments, however, are left for each bank to manage on its own. 

Foreign banks have for the most part hedged that exposure. Most state-run banks and several private-sector Indian lenders have not. 

At one mid-sized state-run bank, the decision so far has been to leave the interest-payment exposure open, on grounds of cost and the reassurance provided by the RBI's intervention-led rally in the rupee. The working assumption there is that interest obligations can be met through spot dollar purchases as and when they fall due, rather than by paying for protection in advance. 

All five bankers spoke on condition of anonymity because they are not authorised to talk to the media. The RBI did not immediately reply to an email seeking comment on the risk posed by unhedged interest payments. 

Why banks are not hedging 

Hedging the currency risk on interest payments costs banks roughly 3% a year for deposits of three- to five-year tenors, where interest is paid at maturity rather than periodically. 

The head of FX trading at a private-sector bank regards that cost as prohibitive, particularly now that RBI intervention has made the risk-reward on the rupee lopsided: in this reading, good news is more likely to set off a sharp rupee rally than bad news is to drag the currency down. 

The rupee reached a two-month high this week on the back of persistent RBI intervention, with the overseas deposits giving the central bank extra firepower, according to analysts. 

What could change the calculation 

That calm may not last. Brent crude is again approaching $100 a barrel, and markets are pricing a 60% probability that the US Federal Reserve raises rates next week. 

With at least half of banks' interest-cost exposure unhedged, a fresh bout of rupee weakness could set off a scramble for dollars. A second banker heading FX trading at another private-sector lender expects that a move towards 96-97 per dollar would be enough to shift banks' current reluctance to hedge.