As the world’s largest recipient of remittances (nearly $135 billion annually) and with international trade ambitions, India has much at stake when its currency comes under pressure. The recent depreciation of the rupee has once again brought the country’s foreign exchange management into sharp focus.

Over the past year, the rupee has weakened by 8-9 per cent, breaching even the 95-per-dollar mark. This slide has unfolded against a backdrop of global uncertainty, including geopolitical tensions in West Asia and expected demand for dollars to finance imports. Such conditions have tested the resilience of India’s exchange rate framework.

India follows a “managed float” regime, where the currency is largely market-determined but subject to intervention by the central bank. This lies somewhere between a free float and a fixed exchange rate system, such as those followed by several Gulf economies. In practice, the difference between these systems is often one of degree rather than kind.

Globally, a handful of “hard currencies”—the US dollar, euro, pound sterling, and Japanese yen—dominate the forex market. These currencies enjoy full convertibility, allowing unrestricted movement across borders for both current and capital transactions. Their deep and liquid markets operate around the clock in an over-the-counter (OTC) environment. Trades are bilateral with limited transparency on volumes.

History shows that turbulence in foreign exchange markets can have devastating consequences. The Asian financial crisis of 1997, for instance, saw several economies collapse under speculative attacks, most notably by large hedge funds. In such scenarios, even central banks often find themselves outmatched, with broader economic and political repercussions.

It is for this reason that India has traditionally exercised caution in opening up its capital account. The recommendations of the second Tarapore Committee in 2006, which advised a calibrated move for convertibility, captured the global experiences till then. The lesson was clear: premature liberalisation can amplify vulnerabilities.

The theoretical underpinning of this cautious approach lies in the “impossible trinity,” a concept which states that a country cannot simultaneously maintain a fixed exchange rate, free capital movement, and independent monetary policy. Policymakers must choose any two, but not all three.

Against this backdrop, the emergence of offshore derivatives such as Non-Deliverable Forwards (NDFs) has posed a unique challenge. These instruments, traded primarily in financial centres like Singapore, Hong Kong, and Dubai, allow participants to speculate on the rupee without holding the currency itself. Settlement occurs in dollars, based on the difference between the contracted and prevailing exchange rates on the date of maturity.

For nearly 30 years or more, the NDF market operated outside India’s regulatory framework, yet exerted a growing influence on domestic currency movements. Following a task force report on offshore derivatives (2016), the RBI moved towards permitting residents to transact in NDF. In 2020, it permitted onshore entities to participate in NDF positions— effectively integrating the domestic and offshore segments of NDFs, going even beyond the task force recommendations.

The opaque OTC nature of NDFs meant that RBI had limited visibility into this market’s size and participants at least in the case of offshore entities. By formalising an instrument it could not fully monitor or control, the regulatory decision arguably exposed the system to unforeseen vulnerabilities.

Recent developments however suggest a course correction and a late realisation of the consequences. In late March, the RBI tightened norms by capping banks’ net open positions and restricting their ability to offer rupee NDFs to corporate clients. These measures, effective from March-end/April 1, significantly reduced speculative exposure.

The impact was immediate. The rupee rebounded sharply, strengthening from near 95 to around 92.5 within days. More importantly, the RBI sent a clear signal to market participants: excessive speculation would not be tolerated.

The broader lesson is unmistakable. Foreign exchange markets are not arenas for experimentation or exuberance, especially when you don’t have a clue to the overall market or its bases.

Exotic instruments like NDFs, however appealing in theory, should not be embraced without a comprehensive understanding of their implications. In a domain as sensitive as currency management, missteps can trigger disproportionate consequences.

Always, given the size of our economy and ambitions, prudence—not adventurism—must guide forex policy. If you don’t understand a forex product and are unable to see it in all its dimensions, don’t overreach. Follow in the footprints of the likes of Bimal Jalan (1997 Asian currency crisis) and Y V Reddy (GFC, 2008).