Indian banks face FX risk on interest payments from overseas deposits as RBI swap facility covers only principal

Lenders have mobilised over $127 billion in such deposits since the Reserve Bank of India introduced the special swap facility as a one-off measure to bolster India's balance of payments amid surging oil prices in June. While the RBI’s facility protects banks from exchange rate risk on the principal amounts of these deposits, the responsibility for managing interest payment exposure falls solely on the banks.

According to the bankers, foreign banks operating in India are largely hedging their interest payment FX exposure, but most state-run banks and several private-sector Indian lenders have not done so. A mid-sized state-run lender’s banker said their institution opted against hedging due to high costs and recent comfort from RBI intervention that supported the rupee.

The current approach among many banks is to cover interest payment dollar needs through spot purchases when required, rather than locking in forward contracts or other hedging instruments. Bankers noted that hedging the FX risk on interest payments for 3- to 5-year tenor deposits costs about 3 per cent annually, a cost deemed prohibitive by some, especially given the recent asymmetric risk-reward profile of the rupee driven by RBI intervention.

The head of FX trading at a private-sector bank said that positive developments are more likely to trigger a sharp rupee appreciation than negative news is to cause depreciation, making hedging less attractive from a cost-benefit standpoint. The rupee recently rose to a two-month high, supported by sustained RBI intervention and the inflow of overseas FX deposits.

However, analysts warn that this respite may be tested as Brent crude prices approach $100 per barrel and markets price in a 60% chance of a US Federal Reserve rate hike next week. With at least half of banks’ interest-cost exposure on these deposits still unhedged, a renewed rupee weakening could trigger a scramble for dollars.

A second banker, who heads FX trading at another private-sector bank, said that a move toward 96-97 rupees per dollar might shift banks’ current reluctance to hedge. The Reserve Bank of India did not immediately respond to a request for comment on the risks associated with unhedged interest payments on these deposits.