NDF currency markets matter more, RBI admits
The Reserve Bank of India (RBI) has got itself in a jam and it will be interesting to see how it gets out of it. While the rupee has fallen 346 paise against the dollar since RBI began its latest round of liquidity squeezing on July 15, the RBI and finance ministry’s view has been that speculation, not just the rupee’s fundamentals, is worsening the collapse—many other currencies have fallen against the dollar. Since a part of the speculation takes place in currency forward markets, RBI and Sebi have been trying to curb trading in currency derivatives since early July. On July 8, RBI prevented banks from taking proprietary positions in currency exchanges, they were allowed to do so only on behalf of clients. A day later, Sebi followed up with raising margin requirements on such trades to 100%, implying they had to be fully financed. Open positions were also curtailed and, between then and now, volumes on NSE have more than halved. The problem, however, as was pointed out even then, global non-deliverable forward (NDF) markets across the globe are several times larger—NDFs are settled in currencies like dollars and pounds since onshore Indians can’t participate in these markets. Between the opaque OTC markets in India and NDFs, the daily volumes are estimated to be in the order of $50 billion as compared to around $5 billion in local derivatives markets.
While the position of top RBI officials has been that, once local futures markets move in a certain direction, the NDF markets will automatically follow, RBI’s latest report suggests quite the opposite. A box in the annual report, on the relationship between exchange rate volatility and futures trading in India, talks of how such trading has increased nearly 100 times over the past 5 years, from R260 crore in September 2008 to R23,440 crore in June 2013. The box talks of how Granger causality runs from speculation (trading) to exchange rate volatility—economists, however, warn that the Granger test is not a foolproof method of causality when the true relationship involves, as it always does, three or more variables. What is more interesting is another box in the same report on the inter-linkages between the onshore currency derivatives and the NDF ones. The box cites several studies, for the won and the rupiah, that show it is the NDF markets that influence the onshore markets, not the other way around. RBI economists then look at NDF and onshore markets for the rupee since 2006 and conclude that while both markets influence each other when the rupee is appreciating, the same is not true when the rupee is depreciating—at such times, it is the NDF market that influences what is happening in onshore markets. In other words, tackling the onshore market may not be of much use. As far as the speculation that takes place outside currency markets—importers rushing to buy more dollars than they need or exporters delaying bringing them back if there is a belief the rupee will further weaken—RBI’s actions are unlikely to work either. A 12% short-term interest rate, for instance, means the cost of speculation will at best be 1% a month. If, however, the rupee depreciates by more than 1% a month, the speculative trade will be profitable even if financed at a high interest rate. It would be interesting to see if RBI has any studies on the impact of lower growth rates on currency values since that is what higher interest rates will ensure.