The recently concluded G-8 meeting in Italy was significant because it was the first time that India and China were seated at the high table of global politics and finance, and there were many observers who believed that these two emerging heroes were the stars of the show. Indeed, there are some who believe that within a decade, the currencies of these two countries would be considered amongst the majors.
Looking at the domestic forex markets, the Indian rupee is certainly well positioned for this; the yuan, however, has a longer road to travel.
As a rule of thumb, the maturity of a forex market can be measured by the ratio of the daily volume traded to the country’s underlying foreign trade (imports plus exports). By that measure, India ranked third, behind Russia and South Africa, of 14 emerging markets we studied, using BIS data for transaction volumes and WTO data for trade volumes. (Since the BIS survey is conducted only once every three years, this data is from April 2007.) China and Brazil (of the BRICs) were far behind, with China ranking last. In fact, total CNY-traded volumes were only about 25 per cent of INR-traded ones.
Of course, the Chinese market has opened up considerably since then, and will likely have climbed a few notches. But India has been the fastest-growing forex market of the 54 covered by the BIS. Daily volumes rose from $34 billion in April 2007 to $53 billion in April 2008, before falling to $44 billion in April 2009.
Despite this, however, the INR market still has a long way to go before it can compete with the majors on a liquidity basis — the trade-adjusted liquidity of INR was less than 40 per cent of the US market in 2007. While INR has doubtless increased its standing by today, there is still a lot of work to be done before the market could be considered highly liquid.
Of course, and despite the continuing constraints on the capital account, the Indian market has matured in several other ways as well. There is increasing breadth of participation, there has been a substantial increase in the volume of options and other derivatives being traded, and the offshore non-deliverable forwards (NDF) market has grown in liquidity and depth. And, most importantly, two-way movements in the price of the rupee are now a matter of course, confirming that our domestic forex market is certainly coming of age.
We developed a Market Maturity Index incorporating a range of other variables — cross-border transaction volumes, domestic volumes traded by non-financial players (companies with real trade and capital exposures), volumes traded domestically by investment entities (hedge funds and the like), and volumes of derivatives transacted on-shore. This confirmed that even in 2007, the INR market was relatively well developed, even more so than if we used the single-dimension liquidity measure. India came in second to Russia, sneaking ahead of South Africa, and crossing the 50 per cent mark in terms of fully mature (again, relative to the US market).
A closer look at the components of this index provides some interesting information, and can provide signals for regulatory focus. We noted, for instance, that while India did well on four of the five indicators, its score on the Investor Activity Sub-index was extremely low — indeed, it was the second lowest (to Thailand) of all 14 markets. While this activity has also most certainly picked up, it gives a clear signal that RBI needs to do more to increase market access for the investment community.
Of course, the ultimate test of maturity of a market is how well it enables users to manage their risk. In a well-developed market, volatility stays reasonably steady over the medium term, which makes managing risk relatively easy. In less mature markets, the volatility itself is very volatile — it jumps around, sometimes because of lack of liquidity and sometimes as a result of stop-start central bank intervention. This makes risk management much more difficult.
We also developed a risk management index (using both market volatility and the volatility of the volatility), according to which, in 2009, India had the best score of 14 emerging markets we studied, just ahead of Russia, streets ahead of China and not too far behind the mature markets. Given that the INR market ranked seventh on this index as recently as 2007, major kudos are due to Dr Reddy and his team for having successfully managed market volatility over the past few years.
Full maturity, here we come — although, to quote John Moore, the Sage of Texas, it is, at best, a mixed blessing.