Rupee FX premiums surge as RBI policy keeps traders guessing on liquidity

The Indian rupee's forward premiums surged to a six-month high on Wednesday after the Reserve Bank of India skipped aggressive new liquidity-draining measures, leaving foreign exchange traders convinced the central bank will rely on sell/buy swaps to manage excess cash.

The market response was immediate. The implied one-year dollar/rupee forward premium jumped 20 basis points to 3.66%, building on a 14-basis-point rise from the previous day. At the same time, the spot rupee remained under pressure, trading at 96.70 to the US dollar—strikingly close to its historic low of 96.96.

The volatility prompted a rare verbal intervention from RBI Governor Sanjay Malhotra. Speaking at a press conference in Mumbai on Wednesday, Malhotra insisted that the Indian currency is actually trading below its true worth.

"By a number of estimates, including the REER [Real Effective Exchange Rate], the rupee is not overvalued; it may be undervalued," Malhotra said, promising that the central bank will step in to support an orderly move toward its "correct value" while keeping extreme swings in check.

Why the policy left traders bracing for swaps

The surge in forward premiums reflects a technical chess match between the RBI and currency desks.

Going into the monetary policy meeting, some market participants expected the RBI to announce direct cash-draining tools, such as an increase in the cash reserve ratio (CRR) for banks. Instead, the central bank held its ground, with Malhotra stating only that the RBI would deploy an "appropriate" mix of tools to manage surplus cash.

For traders, the lack of a formal cash-drain announcement was a clear signal.

"The moment that the policy had no new liquidity measure, traders started positioning for more sell/buy swaps," a currency trader at a private sector bank said.

In a sell/buy swap, the RBI sells dollars in the spot market and simultaneously agrees to buy them back at a future date. This temporarily sucks rupee liquidity out of the banking system. It also drives up forward premiums—the cost of locking in future exchange rates.

The $133 billion liquidity headache

The RBI's need to drain cash is a direct consequence of its earlier efforts to defend the rupee.

When geopolitical tensions in West Asia flared up in late February, driving oil prices higher and putting pressure on India's import-heavy economy, the RBI launched concessions to draw in foreign funds. These schemes, including foreign currency non-resident (FCNR-B) deposits aimed at the Indian diaspora, successfully pulled in nearly $133 billion.

But converting those massive dollar inflows into rupees flooded the domestic banking system with local currency. The RBI must now mop up that extra liquidity to prevent it from fueling inflation or distorting short-term interest rates.

Using sell/buy swaps is a flexible way to manage this surplus, but it comes at the cost of higher forward premiums. Bankers noted that the upward move in these premiums is currently being amplified by the weakness in the spot exchange rate, as the dollar continues to hover near its peak strength against the rupee.