The issue in focus is a flurry of currency swap trades that involved the banks converting rupee-denominated deposits into dollars that were then used to buy foreign sovereign debt including US Treasuries, which are unlisted in India. The Reserve Bank of India warned the banks of a regulatory breach last week, saying they must limit their holdings of such unlisted securities to no more than 10% of investments classified as the non-statutory liquidity ratio portfolio.
Some lenders had racked up exposures of more than $1 billion each by using a regulatory loophole created in February to convert rupee deposits into dollars using a buy-sell swap — buying the greenback now while selling the same amount at a specified date in the future. They then used the proceeds to purchase U.S. government debt and profited from the arbitrage, paying around 3.5% on the local currency deposits and earning 4.9% on the 12-month yield on the currency pair.
As the biggest buyer of the greenback in the forwards market, the RBI was effectively funding some of the trading profits.
The central bank, as part of its intervention strategy, had been offsetting its dollar purchases in the spot market, by entering into sell-buy swaps in the forwards markets. That had swelled its forwards book to over long $70 billion, causing dollar/rupee forward premiums to spike and foreign banks to book arbitrage gains from the trade earlier this year.
Indian entities were net buyers of almost $3 billion worth of Treasuries over April and May, according to U.S. government data, the first inflows from the South Asian nation since October.
The biggest beneficiaries of the swap trades have been overseas lenders in India, which have easy access to large dollar investments, the people said. An email to the RBI was unanswered.
The banks are in the process of unwinding the trade, the people said. They are selling Treasuries and conducting sell-buy swaps — selling the greenback and agreeing to buy at a later date specified in the contract.
The impact of the unwinding was visible in the forward dollar-rupee rates. The implied 12-month yields rose 7 basis points on Friday and Monday after the order and is currently trading at 4.34%.