Fifteen or so years ago, when it first took shape, the Indian rupee non-deliverable forward (NDF) market traded barely a few hundred thousand dollars a week. By four or five years ago, the volume had risen to $2 billion to $3 billion a day, and the terms “NDF arbitrage” and “buying in NDF” became more and more common in dealing rooms.
The Reserve Bank of India (RBI) looked sternly at the offshore market, so only the more aggressive foreign banks helped their clients – in those days, largely diamond traders – to play the arbitrage. From a policy standpoint, it was too small to worry about.
Well, things that are too small to worry about sometimes have a way of becoming too big to control. In April 2010, the NDF market traded about $19 billion a day, a bit more than the $16 billion a day reported by the Clearing Corporation of India Ltd as the volume on the domestic over-the-counter (OTC) market; if you added in the $10 billion a day or so of volume on the domestic currency futures market, you could say that the onshore market was still controlling.
Today, the NDF market is driving things — in April 2011, NDF volumes, at nearly $43 billion a day, were more than double those of the onshore OTC market (about $21 billion a day), and nearly 40 per cent higher than the combined OTC and futures onshore volume. Clearly, the bulk of price discovery for the Indian rupee has migrated offshore. The onshore market closely follows its now full-grown foreign cousin as arbitrage channels have widened, as banks have sophisticated their processes to escape detection and more and more Indian companies have learned to capitalise on the opportunity.
Indeed, our advisory team has been telling me for over a year now that most of the intra-day action in USD/INR takes place while the Indian market is closed. The offshore gap (the difference between any day’s Indian opening rate and the previous day’s closing) has been higher than the onshore gap (the difference between the day’s opening and closing in the domestic market) for the past four years. This means Indian companies could end up missing levels, particularly when the markets are trending.
This has become even more of an issue in recent years, with the bulk of NDF volumes being done in New York, as opposed to earlier, when the market was largely in Singapore (and, to an extent, in Hong Kong and Dubai). This certainly signals the coming of age of the rupee as an investment currency, since it is not only companies that have investments in India that are using this market to hedge their risk, but also currency hedge funds, many of whom take long-term positions in emerging market currencies, expecting that over time the fastest-growing regions of the world will see their currencies appreciate.
The result of all this is that today only Indians living in India are not permitted to take positions in the rupee, unless they have an underlying exposure or are willing to brave the cash flow management issues and relatively poor liquidity of the currency futures markets. And the reference rate that the RBI publishes every day – supposedly one of the firm pillars of the economy – is increasingly determined by the views of global investors.
The tail is wagging the dog fiercely, indicating that it is definitively time to take steps towards making the rupee fully convertible.
The RBI could take a leaf out of the books of certain other central banks (the Philippines, for instance) that permit onshore banks to hold NDF positions to a specified limit. This should be followed by an accelerated programme of bringing down the statutory liquidity ratio and, in parallel, increasing the mark-to-market part of banks’ bond portfolios, so that we can get at least a semblance of a money market. The RBI should also bring back the Mumbai Interbank Forward Offer Rate market — the forwards are, even in this tightly controlled state, already discounting interest rate differentials and will provide the best benchmark for developing a swap market.
Finally, the fact that rupee volatility has actually come down over the past 18 months that the NDF market has been driving things should provide comfort from the irrational terror that opening up will create difficult volatility conditions. Of course, volatility could increase sharply at any time, particularly if the government continues to behave as if it doesn’t have a job. When it does, the current market framework will make it very difficult for Indian entities to hedge themselves since most of the action will happen while we are sleeping.