(Bloomberg) -- India announced steps to deepen its foreign exchange market by allowing local residents trade currency derivatives contracts popular in the offshore market, according to the central bank.

Local lenders with a so-called IFSC Banking Unit — basically having a unit in the International Financial Services Centre currently in GIFT City in the western state of Gujarat — will be permitted to offer non-deliverable forwards to residents onshore, Reserve Bank of India Governor Shaktikanta Das said in his policy speech Thursday. That will enable banks to offer enhanced currency hedging opportunities to their customers.

Banks were earlier allowed to trade such contracts with foreign entities and between themselves in the IFSC in 2020, according to the RBI. The current move widens it to include local players.

“What this will do is boost the onshore-offshore arbitrage in a big way,” said Anindya Banerjee, currency strategist at Kotak Securities Ltd. “The secondary impact is on hedging, this will now give options to the corporates that they can simply hedge and not take or give delivery.”

The rupee rose 0.1% to 81.92 per dollar after falling by a similar margin earlier. 

The banks will have the flexibility of settling their transactions with non-residents and with each other in foreign currency or in rupees while transactions with residents will be mandatorily settled in rupees, the RBI said. 

The move is another example of India’s continued financialization — the growing sophistication of financial markets in the world’s fastest-growing major economy. India began liberalizing its economy in the 1990s but has kept a relatively tight rein on currency trading for both local and foreign investors.

Non-deliverable forwards, or NDFs, are derivatives that allow investors hedge exposure to illiquid currencies by agreeing to settle the difference between contract prices and spot rates. They are usually executed offshore.

Valuable Tool 

In Asia, domestic NDFs, or DNDFs are only used in volume in Indonesia as a monetary policy tool, while secondary market trading is in the development stage, according to a IMF working paper. In the Philippines, the central bank maintains a little-used DNDF facility, it said.

“It also presents opportunities for the central bank to smooth FX volatility - if the RBI begins intervening in domestic NDF markets,” said Maximillian Lin, Asia rates and currency strategist at Credit Suisse Group AG in Singapore. “That could prove to be a valuable tool for the RBI to maintain USD/INR stability.”

India’s Central Bank Unexpectedly Holds Rate; Bonds Rally

The RBI unexpectedly left interest rates unchanged Thursday as the global banking crisis added uncertainty to its economic outlook, though it pledged to hike again if needed.

--With assistance from Malavika Kaur Makol and Divya Patil.

(Updates with analysts comment in the tenth paragraph, updates prices)

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