Kuwait's dinar rose sharply against the US dollar in the forwards market on Monday in response to news that the Kuwaiti central bank would allow local banks to deal in derivatives with foreign banks.

Al Rai newspaper in Kuwait quoted an unnamed source as saying the central bank had "informed treasury managers at banks that it no longer objects to Kuwaiti banks dealing in derivatives with foreign banks, as long as they deal in products approved by central bank regulations."

A trader at a Kuwait-based bank, contacted by Reuters, confirmed the report, saying the central bank had communicated its new policy at a meeting with banks on Sunday.

A senior trader at another Kuwaiti bank said his institution had not yet received any formal communication from the central bank, but was making preparations for such trade. Contacted by Reuters, the central bank made no immediate comment.

One-year dollar/dinar forwards dropped to 130 points, their lowest level since November last year, from 265 points on Friday.

"Forwards are dropping on news that Kuwaiti local banks can start doing swaps and forwards in KWD with foreign banks," another foreign exchange trader in Kuwait said. "This will increase KWD liquidity in the swap market, so the interest cost should come down."

The central bank clamped down on derivatives trading in 2008 as Kuwaiti banks were hit hard by the debt problems of local investment firms during the global financial crisis.

That year the government guaranteed all deposits at banks to avert a panic and the central bank ordered Gulf Bank to raise $1.3 billion in an emergency rights issue, with the sovereign wealth fund taking a 16 per cent stake in the bank.

In the last couple of years, however, many banks have made considerable progress cleaning up their balance sheets, and the central bank has begun relaxing some restrictions. In May this year, Kuwait allowed foreign banks to open multiple branches in the country to spur growth.

LIQUIDITY

The curbs on derivatives trading shrank dinar liquidity in the forex market, increasing the interest rate gap between the dollar and the dinar to some 100-125 basis points, traders said.

"With this policy change, we can flush the market with more KWD via FX swaps, which will push down the interest rate differential, shrinking the arbitrage opportunity," the senior trader said.

The first trader said, "Onshore will now be able to deal with offshore without commercial business behind it...It will allow onshore to feed KWD into the offshore market.

"I don't think speculators are betting on a stronger KWD. I think the increased liquidity will help reduce the KWD premium that offshore had to pay for limited access to KWD...Really, offshore prices are just adjusting to the onshore market."

Expectations that foreign banks will deposit dinars obtained through derivatives deals back into the domestic money market pushed cash rates there down on Monday.

"The six-month cash rate was trading at 1.50 per cent in the interbank market till yesterday, and now there is no bid above 1.20 per cent," the senior trader said. – Reuters