Dollar-rupee forward premia decline on rate pause, Fed hike hopes

Dollar-rupee forward premia, a gauge of the India-US interest rate differential, have declined sharply following an unexpected pause locally in tightening rates and expectations of further increases by the Federal Reserve.

The fall in the forward premia bodes well for importers by bringing down hedging costs, but it disincentivises exporters from selling dollars as their returns reduce.

In the period from March 21 to April 21, the one-year annualised dollar-rupee forward premium rate has eased 19 basis points to 2.35%, currency traders said. Earlier this month, the RBI refrained from raising interest rates citing the need to see the impact of past hikes.

Recent comments by US Fed officials suggest the central bank is not done with raising rates. Consequently, the gap between US and Indian interest rates is seen shrinking.

Typically, a compression in the rate differential between the two countries reduces the relative appeal of domestic assets for overseas investors. Foreign portfolio investors (FPIs) net sold $17.9 billion of Indian assets in 2022, the largest outflow on record, according to NSDL data.

"The interest differential plays a big role in the rupee's forward premium which declined in recent weeks. Also, there is high dollar demand from the importers while there are no incentives for exporters to hedge," Dilip Parmar, research analyst at HDFC Securities said.

In late 2022, the forward premium rate had crashed to an eleven-year low following a far quicker pace of rate hikes by the Federal Reserve than the RBI. Traders cited the unusually low forward premiums as a factor contributing to the underperformance of the rupee at the time.

"Overall, the rupee is likely to face the threat of falling premiums as the US Fed is expected to be hawkish vs the neutral stance by the RBI. Carry traders may start unwinding their dollar short position," CR Forex Advisors wrote.