The strategy of the Reserve Bank of India to move some of its currency activity towards the forward market adds to its problems.
The balancing act to maintain the rupee steady in the midst of heavy foreign inflows while also managing excess liquidity flooding the market with more foreign funds, triggering a vicious cycle of interventions. As of November, the RBI's outstanding forwards book rose to $28.3 billion from a negative $4.9 billion in the 2019-20 fiscal year, reflecting the scale of its operations. That pushed the implied 12-month yields to the highest in more than four years, usually reflecting the interest rate differential between India and the US, fuelling further inflows.
The RBI’s currency intervention works like this -- it buys dollars in the spot market to prevent sharp gains in the rupee. It then sells these dollars in the forwards market to offset the liquidity impact. However, banks need to deliver these dollars to the RBI at a later date, which drives up forward premiums.
The rise in forward premium is also deterring importers to hedge their currency exposure while also impacting stable inflows into the bond market, according to Kotak Securities Ltd. "Speculators are gravitating to short the US dollar and buy rupee due to the high forward premium," said Anindya Banerjee, currency strategist at Kotak Securities said. "In order to prevent speculators from taking the rupee higher, the RBI is being forced to buy more dollars in the forwards market, which is pushing premia higher. This is a vicious cycle."​