MUMBAI, Dec 5 (Reuters) - The plunge in forward premiums to more than a decade low could impact carry trades and fuel the demand for dollars, leading to weakness in the Indian rupee, analysts said.
The USD/INR 1-year forward premium has fallen to 1.70%, down almost 300 basis points year-to-date and the lowest since 2010.
A narrower interest rate differential between the U.S. and India is primarily responsible for the fall in the USD/INR forward premiums. Interest rate differentials have narrowed due to the divergent pace at which the U.S. Federal Reserve and the Reserve Bank of India have raised rates to manage inflation.
Analysts reckon that this collapse in premiums has implications for the spot rupee.
"Such low forward premium makes carry trade unviable and reduces the willingness of exporters to hedge," said Anindya Banerjee, head of research for forex and interest rates at Kotak Securities.
"Both of these reduce supply (of dollars) in the forward market," making rupee more vulnerable to episodes of risk aversion, Banerjee said.
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A carry trade involves buying a higher-yielding currency vis-à-vis a lower-yielding one. The lower the rate differential, the lesser is the motivation to place the trade.
Low forward premiums could also lead to fears of unwinding of existing carry trades, Madhavi Arora, lead economist at Emkay Global Financial Services, said.
Additionally, importers are likely to hedge more due to the "ultra-cheap premiums" and due to the "weakening-to-neutral INR bias", Arora said.
Since the beginning of the year, the Fed has cumulatively raised rates by 375 basis points (bps) while the RBI raised it by 190 bps.
Further, markets are pricing in additional 100 bps Fed rate hikes, including 50 bps next week. The RBI, meanwhile, is expected to pause after increasing rates by 35 bps on Wed and 25 bps in February.
Given the potential for the interest rate differentials to remain narrow, premiums could stay low for some time, say analysts.
The RBI has contributed to the fall in the premiums as it did buy/sell swaps, a transaction that involves buying dollars at the spot date and selling for a future date.
This is being done to neutralize the impact of its spot dollar sales on rupee liquidity and on headline foreign exchange reserves, according to traders.
"At some point, the (RBI) policy intervention strategy will need a re-look to correct this dislocation of premiums," Arora added.
The rupee was down almost 1% against the dollar at 82.56, hovering near its lowest level in over a month.
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