Foreign Exchange Risk Reserve (FERR)

Context

The RBI introduced the Foreign Exchange Risk Reserve (FERR) to curb excessive speculation and ease depreciation pressure on the rupee by increasing the cost of eligible foreign exchange derivative transactions.

About Foreign Exchange Risk Reserve (FERR)

1. Meaning: A regulatory requirement for authorised dealers to deposit cash with the RBI against eligible rupee-linked foreign exchange derivative contracts.
2. Objective: To increase transaction costs, discourage excessive speculation, and ease depreciation pressure on the rupee.
3. Nature: A currency-market regulatory tool, not a conventional hedging instrument or a general reserve requirement for all bank transactions.

Key Features

1. Reserve Requirement: Authorised dealers must maintain a 20% cash reserve with the RBI against eligible contracts covered by the FERR framework, including specified transactions exceeding US$2 million.
2. Cash Deposit: The reserve is maintained with the RBI in cash on a daily basis until the relevant contract terminates, as per applicable rules.
3. Scope: Covers eligible rupee-linked foreign exchange derivatives involving foreign currency positions against the rupee.
4. Regulatory Oversight: Authorised dealers must comply with the RBI’s reporting and reserve requirements.

China’s Model and India’s Approach

1. China’s approach: The People’s Bank of China adjusts foreign exchange reserve requirements to influence currency trading costs and manage the yuan’s value.
2. India’s approach: The RBI has imposed a 20% reserve requirement on eligible transactions to increase costs and ease depreciation pressure on the rupee.
3. Key Difference: India has raised the reserve requirement, while China has also reduced it to discourage bets on further yuan appreciation.

Significance

1. Currency Stability: Higher transaction costs may discourage excessive speculation and ease short-term depreciation pressure on the rupee.
2. Market Discipline: Raises the cost of eligible foreign exchange derivative transactions.
3. Reduced Dollar Demand: May moderate demand for foreign currency and provide temporary relief to the rupee.

Challenges

1. Higher Hedging Costs: Increases currency-risk management costs for importers and other legitimate users.
2. Liquidity Constraints: Daily cash deposits with the RBI limit funds available for other uses until the contract terminates.
3. Limited Long-term Impact: Cannot address underlying causes of rupee depreciation, such as foreign investment outflows, a stronger US dollar, and high oil import costs.
4. Implementation Issues: Reserve calculations and compliance requirements may increase banks’ operational burden.

Way Forward

1. Policy Coordination: Combine FERR with foreign-exchange intervention and measures to strengthen the external sector.
2. Affordable Hedging: Ensure businesses can manage currency risks at reasonable costs.
3. Impact Assessment: Monitor effects on speculation, market liquidity and import costs

FAQs

Q1. Who are authorised dealers?

Ans. Authorised dealers are banks or other entities permitted by the RBI to deal in foreign exchange.

Q2. What is the prescribed FERR ratio?

Ans. Banks must keep a 20% cash reserve with the RBI against eligible foreign exchange contracts.

Q3. How can FERR affect importers?

Ans. FERR may increase the cost of protecting foreign currency payments against exchange-rate changes, making it more expensive for importers to manage currency risks.

Q4. Can FERR permanently prevent rupee depreciation?

Ans. No. The rupee’s value also depends on foreign investment, oil prices, the strength of the US dollar and other economic factors.

Q5. What is currency hedging?

Ans. Currency hedging is a method of protecting against potential losses caused by exchange-rate fluctuations; FERR is a regulatory measure, not a hedging instrument.