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The narrowing of arbitrage between the domestic rupee market and the non-deliverable offshore market has eased the need for an aggressive central bank intervention in the currency market.

The differential that used to be as high as 40 paise has shrunk to about 5 paise as domestic banks that could trade in the non-deliverable forwards (NDF) instead of just the foreigners with access to the NDF market before RBI letting banks take position.

With NDF, an offshore over-the-counter derivative market, it is only the differential of exchange rates (between contract booking rate and rate on contract maturity date) that a local bank has to settle in dollar terms at the time of contract maturity.

Local banks take speculative positions and act on behalf of the central bank seeking to intervene in the offshore derivative market, which was earlier the ‘fiefdom’ of foreigners.

“Wild swings in USD/INR was earlier driven by offshore driven NDF which was plugged when RBI allowed a level playing field to Indian banks to participate” said Bhaskar Panda, executive vice president at HDFC Bank. Wider arbitrage opportunities used to put more pressure on the rupee.

“With narrowing arbitrages now, it added to the central bank’s comfort in managing the exchange rate volatility,” he said.

In simple terms, the differential between one-month offshore forwards (NDF) and onshore forwards sparks arbitrage trades. Wider the differential, better the profits in arbitrage trades with speculators betting on it.

Select Indian companies with overseas business used to buy forward contracts onshore only to sell in the NDF contracts, where yields were higher due to the rate differential. This was under a depreciating rupee scenario.

“In the current circumstances, arbitrage trades would have encouraged speculators to short the rupee,” said Anindya Banerjee, currency analyst at Kotak Securities. “We had seen its adverse effect in erstwhile instances.

This time around, it has diminished, minimising chances of more intense RBI intervention to curb any undue wild swings.”

With a narrowing differential such arbitrage opportunity has not so far appeared this time around.

About two years ago the Reserve Bank of India permitted banks to participate in the NDF.

The central bank now intervenes in the NDF with local banks acting on behalf of the central bank via GIFT City, an international special economic zone. For a local bank to trade in NDF, it must have a branch in the Gujarat GIFT City.

Many local exporters/importers are now missing such opportunities to make quick bucks, said a dealer familiar with those deals.


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