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With the transition to a market-based system for determining the external value of the Indian rupee the foreign exchange market in India gained importance in the early reform period. This forum provides an important platform for interaction amongst the corporate treasurers, finance professionals and market participants and it is being held at a time when the financial world is beset with uncertainties regarding economic growth prospects, oil and commodity prices and monetary policy stances of major economies.
Given this uncertainty as the backdrop, I would like to touch on some key issues which impact the development of Indian forex markets. Foreign exchange market in India has developed significantly in the post-reforms era following the phased transition from a pegged exchange rate regime to a market determined exchange rate regime in and the subsequent adoption of current account convertibility in With the abolition of liberalized exchange rate management system LERMS in , the exchange rate of the rupee became market determined.
The depth of the foreign exchange market can also be gauged from the fact that the bid-offer spread in USD-INR pair is quite narrow now. In the context of integration of Indian financial market with international markets, the approach of Reserve Bank of India to market development has been that of cautious gradualism, informed by the experience of other developed and developing countries. Even within the constraints imposed by a gradualist approach, Reserve Bank and the Government of India have taken several steps that include progressive liberalization of capital flows, calibrated increase in investment limits for Foreign Institutional Investors FIIs in government and corporate debt, introduction of Qualified Foreign Investor QFIs as a separate investor class, expansion of the menu of risk management instruments, etc.
Proper risk management system is another issue of utmost importance where significant progress has been made. The setting up of Clearing Corporation of India, which commenced its operations in , has helped in significantly enhancing the efficiency and security of settlement system for government, money market and forex market.
As far as Over-the-counter OTC derivative products are concerned, significant progress has been made in the recent past. The reporting arrangement covering OTC foreign exchange derivative trades between Authorised Dealers AD banks and their clients has now been fully operationalised. The forex market conditions have generally remained orderly with intermittent episodes of volatility in the past two decades on account of external or internal factors or a combination of both.
The day-to-day movements in the exchange rate of the rupee are market determined, i. An issue of paramount significance in this context is the volatility in capital flows to EMEs including India.
As I mentioned above, India, like most other EMEs, is facing the challenges associated with volatile capital flows and is susceptible to shifts in risk appetite of international investors on account of external developments completely exogenous to whatever happens in the country.
This was amply demonstrated during the May-August episode of taper tantrums. The mere hint by Chairman Bernanke about possibility of an early QE-tapering led to an exodus by the FIIs, especially in the debt segment. The rupee went into a tailspin and depreciated sharply by over 19 per cent, touching a historic low of The various measures taken by the Reserve Bank in conjunction with the Government of India helped in restoring stability to the forex market with the rupee recouping most of its losses during September-October The rupee exhibited greater two-way movements during on the back of sustained FII inflows, especially in the debt segment.
As compared to major currencies as well as some of the other emerging market peers, the Indian Rupee has exhibited greater stability during the recent months. Earlier, having large reserves was considered wasteful on account of quasi fiscal costs but the global financial crisis led to a renewed debate about the adequacy of reserves, as EMEs with large reserves could weather the crisis relatively better leading to the current thinking that the benefits of holding larger reserves far outweigh the costs, especially in the case of EMEs like India.
Additionally, the sharp downward movement in imported commodity prices, especially crude oil prices, has also buoyed the market sentiment and contributed to the resilience of the rupee in the recent months. The stability exhibited by the exchange rate of the rupee in the recent months, despite completion of the process of tapering of QE by the Federal Reserve in October , reflects the improved confidence of global investors in the Indian economy.
Overall, financial markets in India, unlike global financial markets, have exhibited greater stability and resilience. Additionally, unlike commodity exporting countries like Russia, India stands to gain substantially from the steep fall in crude oil prices through improvement in current account deficit, fall in inflation, reduction in fiscal burden on account of oil subsidy, etc.
All these factors would contribute towards ensuring stable conditions in the domestic forex market in Normalisation of US monetary policy and weak global growth pose significant risk. However, potential for volatility still remains, which emanates largely from external factors.
Despite significant improvements in macro-economic fundamentals and the overall prospects of the Indian economy, as outlined above, the spillover impact from global financial market volatility to India could be disruptive, especially once normalisation of the US monetary policy stance begins with the commencement of tightening of interest rate cycle in the US in and beyond.
The US dollar has already appreciated significantly against most of the major as well as EME currencies in the recent period with the dollar index rising sharply from the second half of , taking cues from the divergence in the monetary policies pursued by major central banks coupled with shifts in economic outlook.
While the US has completely tapered off its QE, the Euro Zone and Japan have increasingly resorted to QE for propping up their economies against the backdrop of faltering growth, leading to depreciation of their currencies.
Market volatility in many EMEs has increased. In fact, the Indian rupee has remained relatively stable amidst volatility in other markets. Though, it is unlikely that the episode of taper tantrum will be repeated this time as the markets have already factored in the likely tightening of the US interest rates, some volatility in the EME forex markets is inevitable.
Risks also emanate from a prolonged period of weak global growth, which could hamper Indian exports. Though global growth may receive some fillip from decline in oil prices, this may be largely offset by negative factors like decline in investment associated with diminishing medium-term growth prospects.
Oil exporting countries are facing enhanced external and balance sheet vulnerabilities on account of steep fall in oil prices. Stagnation and low inflation continue to remain a concern in the Euro area and Japan and geopolitical tensions continue to remain high.
The recent developments in Greece have added a new dimension of uncertainty to Euro. China is also facing significant slowdown in growth momentum and the outlook for EMEs also remains weak.
Thus, the uncertain global growth prospects pose significant risks to stability of Indian financial markets. A sudden reversal in commodity prices, especially crude oil prices, could enhance volatility in the Indian financial markets, especially the forex market. Thus, given the uncertainties, it makes eminent sense for an EME central bank like the RBI to have sufficient tools in its toolkit and use them in a proactive manner. Unhedged foreign currency exposure of corporates remains a major risk factor for EMEs like India.
Corporates in many EMEs have taken advantage of benign global financial conditions to increase their overseas borrowing and leverage. In a recent Working Paper, Bank for International Settlements BIS has traced a strong relationship between the widening yield differential and growth in off-shore USD credit both in terms of bank credit and dollar bond issuances of non-bank corporates outside the US.
This could expose the corporates in EMEs with large forex exposure to significant interest rate and currency risks unless these positions are adequately hedged. Greater corporate exposure could, in turn, increase vulnerabilities for both local banks and the financial system more broadly. Shocks to interest or exchange rates could generate adverse feedback loops, especially if credit risks prevented the rollover of existing bank or bond market funding.
A point of comfort for India is that the Indian corporates do not contribute significantly to this increased exposure basically because of the macro prudential measures put in place in India ; however, if a wave of corporate defaults happen in other EMEs, this can lead to some cascading impact on India and its financial markets. I feel that against the backdrop of imminent tightening of US interest rate cycles, and there are sufficient indications in this regard, there is a pressing need on the part of corporates to improve their risk management practices in order to preclude the possibility of huge losses in the event of unexpected developments.
In this context, hedging of forex exposure by the corporates assumes paramount significance. While large treasury profits are alluring, it should not become an all-consuming passion exposing the corporates to unacceptable risks.
Every corporate needs to formulate a well-deliberated hedging policy and ensure strict adherence to it. The RBI has been sensitizing the corporate and the banking system about the need for hedging and has devised appropriate regulations in the recent period but it is more important that corporates take these exhortations seriously and act accordingly.
Apparently, there exists some misconception that RBI will always lean against the wind in the event of sharp depreciation of the rupee but this may not always be true. Banks also need to diligently factor in these risks while extending credit to corporates and hedging by corporates needs to be encouraged further to reduce risks.
India has been pursuing calibrated approach towards capital account liberalization and a more liberalized capital account would require a deep and liquid forex market with wide variety of instruments, especially hedging instruments, to reduce volatility resulting from large capital flows. Governor Rajan in his statement on taking office on September 4, stated the following in regard to internationalization of the rupee: This will also mean that we will have to open up our financial markets more for those who receive rupees to invest it back in.
We intend to continue the path of steady liberalisation. Reducing the interest in the NDF market through liberalization of currency futures. The Non Deliverable Rupee Market is a symptom of growing international interest in a currency which is not fully convertible.
The growing importance of India in the global economy has led to an increasing interest in the rupee. Thus, the interest in the rupee along with the existence of capital controls in the onshore market has led to the development of an offshore rupee market mainly in Singapore, Dubai, London and New York. Going forward, it is imperative to try to bring the offshore activities onshore, to the extent possible, in order to deepen the domestic markets and thereby enhance the trickle-down benefits.
This may help in bringing some offshore participants onshore and reducing the reliance of such participants on the offshore market. Better alignment between OTC and exchange traded markets for currency futures.
In the case of currency futures market in India, due to cash settled nature of the transactions undertaken on the exchanges with no mandated requirement for delivery, there is a non-level playing field between OTC and Exchange traded markets.
There is a need for regulatory alignment between OTC and exchange traded segments of the currency futures market. It is generally understood that exchange traded currency futures, rather than being used by the real sector are mostly being driven by speculative interests. Currently, the liquidity in exchange traded market is confined to very short-term.
If such products are to be positioned as a credible hedging products then the liquidity has to extend beyond short-term. These issues need to be addressed going forward for development of a deep and liquid currency derivatives market for hedging currency risks.
While there is increasing interest amongst end-users in using currency options, not many banks in India have scaled up their expertise in this area and the option activity remains confined to just a few banks. This prevents development of an active options market. It is necessary that banks enhance the necessary skill-sets in this product which has been catching the attention of the end-users. Liberalization of net open position limits NOPL of banks.
Another important area is the net open position limits NOPL of banks. Large open forex positions have systemic risk implications and need to be monitored closely. However, relaxation in these limits is essential to deepen the currency market as excessive restriction on speculation hinders the development of the market.
Thus, a fine balance has to be maintained between the need to minimize risk and deepen the forex market in India. Data collected by RBI reveals that, atleast in the last few months, banks have healthy bi-directional views on Rupee in contrast to general unidirectional bias , which have helped promote healthy markets. RBI has already chalked out a programme to move over to trade-based financial benchmarks from a polling-based system in a gradual and non-disruptive manner.
In the last few months, stung by the regulatory actions abroad, many banks have shown a great amount of reluctance to participate in the polling process in India. It needs to be recognized and borne in mind that that the move from a polling based system to trade-based system is a carefully calibrated process and cannot be accelerated at the cost of bringing the system to disruption. It is, therefore, necessary, in the interests of market integrity, for the active players to continue to participate in the polling process till the alternative system is on track.
Going forward, further development of forex market would include introduction of more instruments, particularly derivative products, widening of participants base, commensurate regulations along with modern risk management systems and improved customer service. Additionally, there is a need to increase liquidity in long-term hedging products. Development of markets for long-term hedging products is necessary to reduce risk in the system. Use of most advanced payment and settlement infrastructure in the forex market is required along with improvement in other market infrastructure.
Reforms in the foreign exchange market will continue to be an on-going process and will have to be harmonised with the evolving macroeconomic environment and the needs of the real economy as well as the development of other segments of the financial market, particularly the money, the equity and the government securities markets. Skip to main content.
Search the Website Search. Indian forex market has come a long way Foreign exchange market in India has developed significantly in the post-reforms era following the phased transition from a pegged exchange rate regime to a market determined exchange rate regime in and the subsequent adoption of current account convertibility in Forex Market Movements The forex market conditions have generally remained orderly with intermittent episodes of volatility in the past two decades on account of external or internal factors or a combination of both.
Positive developments during lending support to the rupee The various measures taken by the Reserve Bank in conjunction with the Government of India helped in restoring stability to the forex market with the rupee recouping most of its losses during September-October