Surge in Dollar Forward Contracts Raises Concerns for Asian Central Banks' Currency Strategy

Asian central banks face increasing risks as they rely on derivatives to shield currencies from a strong dollar

Across Asia, central banks are increasingly turning to derivatives, particularly dollar-forward contracts, as a strategy to protect their currencies from the persistent strength of the US dollar. However, this approach has raised questions about the long-term sustainability of such tactics and whether they may be deferring currency risks rather than addressing them.

In December, the Reserve Bank of India (RBI) reached an all-time high in its net dollar short forward position, amounting to $68 billion. This means the RBI has agreed to sell a significant amount of dollars at predetermined prices in the future. Similarly, Bank Indonesia (BI) saw its net short position surge to $19.6 billion, marking its highest level since at least 2015. This growing reliance on forward contracts highlights a shift in the approach of these central banks toward defending their local currencies.

The shift towards using derivatives such as forward contracts, alongside traditional spot market interventions, is seen as a way to push back against the dollar without immediately depleting foreign reserves. While this strategy has short-term benefits, concerns are rising about the potential risks associated with deferring currency depreciation.

Currency strategist Dhiraj Nim of Australia and New Zealand Banking Group expressed concern that this approach could simply delay inevitable depreciation, potentially leading to more severe currency challenges in the future. By utilizing derivatives, central banks can keep their foreign reserves high, which gives an impression of confidence, but this method may just be pushing the problem forward.

Both the Reserve Bank of India and Bank Indonesia have acknowledged using derivatives in their currency interventions, though they did not respond directly to inquiries regarding the specifics of their strategies. India and Indonesia have faced significant depreciation in their currencies over the past year, with both the Indian rupee and Indonesian rupiah losing more than 3.5% of their value against the US dollar. However, recent signs indicate that the rupiah saw a slight recovery, gaining 0.4% on Monday.

The political landscape, especially with the election of Donald Trump as US President, has further complicated the situation for emerging-market central banks. Trump's threats of tariffs have triggered waves of currency depreciation as emerging-market economies face pressure to prevent their currencies from becoming too weak. Additionally, Trump's administration has voiced concerns about currency manipulation, placing these countries under further scrutiny.

Currency strategist Claudio Piron from Bank of America emphasized the sensitivity of the issue, particularly as the US administration closely monitors global trade and currency policies. With Trump's stance on currency manipulation, emerging-market central banks are walking a fine line between intervening to protect their currencies and avoiding excessive interference in foreign exchange markets that could attract political attention.

Using dollar-forward contracts comes with several advantages for central banks. These derivatives can help protect against currency depreciation without the immediate need to dip into foreign reserves, which would reduce a country’s perceived financial stability. Forwards also enable central banks to mask their intervention in the market, reducing the risk of drawing unwanted political attention, particularly from the US government.

Countries such as Malaysia have adopted this strategy as well, with its net short forward position rising to approximately $27.5 billion in November, after an increase of $4 billion over the past year. Meanwhile, the Philippines adjusted its approach, reducing its net long forward position to just $874 million, according to data from the International Monetary Fund (IMF).

On February 11, the Reserve Bank of India was suspected of intervening heavily in both the spot and forward markets to prop up the rupee. The currency rose nearly 1%, marking its biggest increase since November 2022, triggering stop-loss orders among traders betting against the rupee. This confirmed that the RBI was actively managing the rupee’s value through a combination of market strategies.

The recent slight decline in the US dollar has provided some relief for central banks, offering a temporary break from the pressure of defending their currencies. The US has delayed or canceled tariffs on several countries, including Canada, Colombia, and Mexico, reducing the likelihood of escalating trade tensions. As a result, the US dollar has weakened by roughly 1.7% since the beginning of the year.

Furthermore, the appointment of Sanjay Malhotra as the new Governor of the Reserve Bank of India signals a potential shift in India’s currency management strategy. Analysts suggest that the RBI may be adopting a more flexible stance towards managing the rupee’s exchange rate. There are indications that the RBI has reduced its reliance on non-deliverable forwards, focusing instead on onshore operations to improve domestic liquidity.

Despite the recent dollar decline and potential policy shifts, the use of forward contracts by central banks remains a preferred tool for currency management. Currency strategist Aaron Hurd from State Street Global Advisors noted that the forward market offers significant advantages with relatively few downsides. While central banks must be cautious not to accumulate an excessively large forward book, this is not an immediate concern given the current levels of intervention.

In conclusion, while currency forwards provide a flexible and less costly alternative to traditional intervention strategies, they carry the risk of prolonging the challenges posed by a strong dollar. As central banks continue to rely on this approach, the long-term implications for currency stability and economic health remain uncertain.