Deepak Shenoy on what's happening with the rupee | Subtext by Zerodha

ELI5/TLDR

Indian banks found a neat arbitrage trick: buy dollars onshore cheaply, sell them in the offshore NDF market at a premium, pocket the spread. The positions ballooned to billions. RBI caught on, capped bank exposure to $100 million each, and then shut down the corporate workaround too — collapsing the trade and briefly swinging the rupee by a full point. Deepak Shenoy walks through the entire forex plumbing from Nostro accounts to NDF settlement, and makes the case that India should stop fighting volatility and just internationalize the rupee.

The Full Story

How the rupee actually trades

Every dollar transaction in India runs through the banking system. You don’t hold dollars yourself — your bank holds them in a correspondent account (a Nostro account) at a US bank. SBI’s dollars sit at JP Morgan. When Goldman Sachs buys Indian stocks, the rupees move between Indian bank accounts, the dollars move between US bank accounts, and the banks intermediate. Spot settlement is T+0 or T+1 at whatever rate the market clears.

If you need dollars a month from now and want to lock in a rate, you buy a deliverable forward. The forward price bakes in two things: interest rate differential and directional risk. In normal times, a one-month forward might be 20 paise above spot. In volatile markets, that premium blows out.

RBI as the market’s shock absorber

When $5 billion of foreign investment shows up at once, the rupee would appreciate sharply — too many dollars chasing rupees. RBI steps in, prints rupees, buys the dollars, and adds them to forex reserves. The exchange rate barely moves.

The reverse is messier. When dollars leave, RBI sells dollars from reserves and absorbs rupees out of the banking system. Those rupees vanish — they’re no longer available to banks. Suddenly there’s a liquidity crunch. RBI patches this with short-term lending facilities (variable rate repos) where banks can borrow overnight or for a few days until flows normalize.

“Any rupee that goes back to RBI goes out of the banking system. It is no longer available.”

Since 2016-17, the system has mostly been in surplus — banks parking excess cash with RBI above their CRR requirements.

The NDF market: suited-booted satta

The non-deliverable forward is an offshore bet on the rupee denominated entirely in dollars. No rupees change hands. If I take a $100 million NDF position betting on a 1% rupee decline, my actual exposure is just $1 million — the cash-settled difference. The notional numbers look enormous but the real capital at risk is tiny.

“The whole NDF market is the suited-booted equivalent of a dabba trade.”

NDFs grew because offshore participants found India’s documentation requirements too cumbersome. Foreign investors who might sell Indian stocks tomorrow wanted to hedge today, but couldn’t produce import invoices to satisfy FEMA rules. So they hedged offshore instead.

The arbitrage that ate RBI’s reserves

RBI allowed Indian banks to participate in NDF markets up to 25% of their tier-one capital. The idea was to bring onshore and offshore rates closer through arbitrage. It worked — but too well.

When the rupee started weakening, NDF prices diverged from onshore rates by 50+ paise. Banks spotted the spread: buy dollars onshore at 93, sell them offshore at 93.5, lock in half a rupee risk-free. SBI alone built a $5 billion position.

The catch: onshore positions are deliverable. The bank actually has to source $10 billion in real dollars from the Indian market. The only entity with that kind of supply is RBI. So RBI was hemorrhaging reserves to fund what was effectively speculative activity dressed up as arbitrage.

RBI shuts it down — twice

First move: cap each bank’s NDF-linked position at $100 million, effective by April 10. Banks had days to unwind billions.

Unwinding meant doing the reverse trade — selling dollars onshore, buying back the NDF. But the spread had widened from 50 paise to 90 paise. Banks faced a 40 paise loss per dollar on enormous positions.

So banks got creative. They went to importers and multinationals and said: take these contracts off our books. You have genuine import documentation, you have foreign arms that can hold the NDF leg. The corporate took over the position, the bank escaped the loss, and the rupee whipsawed — dropping to 93.7 before bouncing back to 94.7 in a single day.

RBI’s second move: ban banks from booking new NDF contracts on behalf of those same corporates. No renewals, no rebookings on the same import. The corporate escape hatch was sealed.

“RBI said this is nonsense. I want to limit your participation to only $100 million per bank.”

What actually moves the rupee

With the speculative plumbing dismantled, genuine fundamentals reassert themselves. Three things matter:

Crude oil prices. India’s largest import. When crude was at 60, the current account was manageable. At 125 (where India was buying recently), dollar demand surges. Even after a drop to 95, it’s still elevated.

Foreign institutional flows. FIIs pulled out over 25,000 crores in just 3-4 days — partly genuine selling, partly funding the NDF arbitrage. If they return, dollar supply improves.

Gulf remittances. Geopolitical disruption may delay inward remittance flows, reducing dollar supply.

The bigger argument: let the rupee float

Shenoy’s sharpest point comes at the end. RBI has been a net buyer of dollars for years — it didn’t want the rupee to appreciate. India’s forex reserves hit $600 billion against a current account deficit of $50 billion. That’s 12 years of import cover. If RBI was comfortable suppressing appreciation, why panic over depreciation?

“If we wanted the RBI to not let the rupee appreciate, then why should we argue that the RBI should not let the rupee depreciate? It’s nonsense.”

His prescription: internationalize the rupee, open the FEMA act, let retail participants trade forex, and accept volatility as the price of a real market. Restricting participation to banks and corporates is what created the arbitrage monster in the first place.

“Any market that is not speculative is not a market. You need the speculators otherwise you don’t have a market.”

Claude’s Take

This is an exceptional explainer. Shenoy takes what could be an impenetrable topic — NDF arbitrage, Nostro accounts, variable rate repos — and builds it up from first principles in a single continuous conversation. The interviewer (Krishna from Zerodha) asks the right clarifying questions at the right moments.

The NDF-arbitrage-to-corporate-pass-through chain is genuinely novel reporting. Most coverage of rupee moves stops at “RBI intervened.” Shenoy traces the full mechanics: how banks built positions, why the onshore side required real reserves while the offshore side didn’t, how the unwinding created the one-day whipsaw, and how corporates briefly became the escape valve.

His closing argument about internationalizing the rupee is worth sitting with. India has 12 years of import cover in reserves. The instinct to restrict and control is what created the distortion. But that’s also easy to say when you’re not the central banker responsible for keeping inflation anchored and the current account manageable.

Score: 8/10. Dense, mechanically precise, builds genuine understanding of a system most people never see. Loses a point for the conversational format creating some repetition, and for not addressing the inflation/stability tradeoff in the internationalization argument.