Jaimini Bhagwati: Exchange rates & currency derivatives

Given the circumstances, it is difficult to pursue sound exchange rate management policies.

In the last few weeks attention has been repeatedly drawn to the management of the rupee-dollar (INR-US$) exchange rate in various forums including the columns of Business Standard. There are basic differences of opinion among commentators about the extent to which the Reserve Bank of India (RBI) should manage the rupee-dollar exchange rate and the time taken for exchange rate changes to impact inflation. At the risk of immense oversimplification, those who are concerned about export competitiveness advise the RBI to prevent the real effective INR-dollar exchange rate from appreciating. Those who insist that inflation targeting should be the RBI's principal concern prefer minimal RBI intervention in the currency market.

All other factors being constant (never happens in the real world), export promotion usually wins, supported by the plausible reasoning that real INR appreciation could impact the creation of new jobs negatively. However, in an environment in which inflation becomes a political hot potato, policy-makers need to be seen to be combating inflation. In such situations, the RBI's degrees of freedom in managing INR exchange rates are reduced. It is invariably difficult and time-consuming to take the steps needed to ease supply side constraints including labour reforms, improvements in infrastructure and reduction of Customs duties. As a result, immediately visible demand side solutions are often adopted. This is politics at its most basic.

Amidst these contradictory opinions, it has been suggested that now is the right time to push ahead with currency and interest rate derivatives. Forward exchange rates between any two sets of currencies are derived from the interest rates in those currencies. As is commonly known, Fisher's interest parity equation links interest rates and spot and forward exchange rates between two convertible currencies. This is: F/S = (1+r*)/(1+r), where F is the forward exchange rate over one time period, S the spot exchange rate, r* the interest rate over the same time period in the foreign jurisdiction and r the corresponding interest rate in the local currency. F can be derived if the spot exchange rate and the interest rates in the two jurisdictions are known. This is not to suggest that future spot rates will necessarily follow this equation. What all this says is that there is no risk-free way of making money by borrowing in a lower interest rate currency, converting at the spot rate and investing in another currency and converting back to the local currency, at a forward exchange rate contracted at the outset, and repaying the borrowed funds with interest. Even if arbitrage opportunities were to arise momentarily, the high volume of exchange rate transactions in international currency markets would make such opportunities disappear very quickly. The large volumes of yen carry trades are based on speculators taking the risk of borrowing in the yen, converting at the spot exchange rate e.g. to the dollar, investing in that currency and converting back into the yen to repay the principal with interest. This is profitable as long as the yen does not appreciate enough to wipe out the differential between yen and dollar interest rates. The carry trade speculators take open foreign exchange risk positions.

Spot INR exchange rates are not market-determined since INR interest rates are not adequately deregulated and India's capital account is less open than convertible currency countries. Plus, there is a stop-go approach to capital inflows, e.g. policies relating to external commercial borrowings. The choice of the word adequate is deliberate--there are no perfectly deregulated interest rate markets anywhere. It follows that currently INR forward exchange rates are not adequately market determined.

An overwhelming fraction of traded INR debt is made up of central government bonds. State governments obtain "market" loans from banks, financial institutions and companies and these are not traded. However, let us assume that interest rates on all central government bonds and state government loans are market-determined. The total volume of central government bonds, as of end March 2006, was 38.4% of GDP and state governments' market loans totalled 8.6% of GDP. In comparison, the volume of debt raised through the central and state governments' small savings, pension, provident fund, deposit and other schemes, which carry administered interest rates, amounted to 38.9% of GDP. That is, a significant portion of government debt is contracted at non-market determined interest rates. Further, for on-going requirements the central and state governments may continue to mop up savings through administered interest rates to reduce the impact on benchmark interest rates.

The importance of building liquid debt markets has been periodically reiterated and the benefits that would accrue to the insurance and pensions sectors are widely acknowledged. As compared to the past, efficient settlement and trading platforms are available for trading in debt securities. However, a basic problem is the large stock of outstanding central and state government debt contracted at administered rates. Market makers in debt securities are likely to be apprehensive about unhedgeable market risks since government action, e.g. to offer investors additional schemes at administered interest rates, could affect the bond market unpredictably. This factor also inhibits the development of asset backed securities' markets.

If we think back to 1999-2000, the "badla" market in equities was still prevalent. It was recognised at that time that introducing equity derivatives would be sub-optimal till such time as the badla market was eliminated and rolling settlement introduced. Following this line of thinking it would be somewhat premature to push exchange traded currency or interest rate derivatives till we deregulate interest rates further. The over-the-counter (OTC) currency and interest rate derivatives, namely currency and interest rate swaps, exist, allowing institutions to hedge currency and interest rate risk.

To summarise, given the relatively large volumes of government debt issued at administered interest rates, wavering policies on capital inflows and the need for publicly visible steps to be taken against inflation, it is difficult to pursue consistently sound exchange rate management policies. Additionally, there are phasing and prioritisation issues. As we move towards exchange-traded INR currency and interest rate derivatives, the interest rate regime needs to be deregulated further. Effectively, the foundations of the INR spot exchange rate market need to be strengthened before we build elaborate superstructures of currency derivatives on them.

j.bhagwati@gmail.com