The Reserve Bank of India has warned that inflation is likely to increase in the second half of the year in the wake of sharp depreciation of the rupee against the dollar.
The central bank’s Annual Report for 2012-13 also said the rupee value is at times influenced by trading in non-deliverable forwards (NDF) — foreign exchange derivative instruments that are based on non-convertible currencies such as the rupee and traded in international financial centres like Singapore.
“Continuing concerns relating to the elevated level of the current account deficit and its financing coupled with weakness in FII flows have played a major role in weakening the rupee,” the RBI said. The pass-through of the depreciation of the rupee exchange rate by about 11 per cent in the first four months of 2013-14 is incomplete and will put upward pressure as it continues to feed through to domestic prices, the central bank said. Currency depreciation is, however, not unique to India; other emerging market currencies have witnessed similar trends. It also includes major currencies like the euro, which has depreciated against the US dollar in this period.
“(Our) analysis suggests that there is a long-term relationship between the spot and NDF markets for the rupee,” the RBI said. Being an offshore market, the NDF market remains outside the regulatory purview of local authorities. NDF is a foreign exchange derivative instrument traded over-the-counter and is operated in currencies that are not freely convertible. NDF contracts enable hedging of exchange rate risk, irrespective of any restrictions arising in the country of origin. Even though an NDF contract is similar to a regular forward foreign exchange contract, it does not require physical delivery of currencies at maturity and is typically settled in an international financial centre in foreign currency.
In the Indian context, onshore financial institutions are not allowed to transact in the NDF markets. However, since domestic banking entities are allowed specific open position and gap limits for their foreign exchange exposures, there is scope for domestic entities to participate in the NDF markets to take advantage of any arbitrage. Further, foreign banks and corporate entities with an international presence can participate in NDF market.