No Great Expectations

The most recent relaxation, a result of intensive bank lobbying with the Reserve Bank of India (RBI), allowed banks to use hedge products on their own accounts. Six months back, the RBI had allowed them to sell hedge products to their corporate clients without taking prior permission from the central bank. Hence it was only a matter of time before banks too were allowed the same facility.

Among the changes effected by the RBI in the last one month include: allowing the authorised forex dealers to offer forward cover for beyond six months without prior permission from RBI, greater freedom to the forex dealers with respect to remittance of foreign exchange and allowing banks the use of hedge products for managing their forex liabilities more effectively.

 

Most observers say that the twin relaxations pertaining to forward cover and hedge products will hardly create a ripple in the forex markets. This perhaps in keeping with the central banks style of reform, where the gradual relaxations have not resulted in any huge increase in market activity.

In January 1996, corporates were allowed to buy cross-currency swaps. The initial excitement generated six deals in the first week and then it was all forgotten. The decision to allow corporates to buy forex derivatives without prior RBI permission did away with an administrative hassle. As was only expected there have hardly been any deals that have been put through.

Experts point out that the real activity will come commence once the RBI integrates the domestic money market with the foreign exchange market. The current crop of measures cannot be construed as leading to the beginning of a more active market in hedge products, in that regard. The reason for this is that the scope for using the hedge products is limited.

On the other hand the ability on part of the banks to offer forward cover beyond six months is constrained by the absence of a well developed domestic money market.

Earlier, banks could offer forward cover even beyond six months, say, one year. But for this they had to take specific permission from RBI which used to clear them on case-to-case basis. These deals were on a back to back basis with the banks acting as an intermediary between two parties. Hence, the deals of long-term forward covers were few and far between.

The only option foreign currency borrowers, then, had was to roll over forward covers every six months. Till 1995, corporates were widely taking this option to hedge their forex risk. Contracts were entered into for long tenors at the beginning only with the agreement that forward covers will be rolled over at pre-determined charges and historic currency rates. This meant that the actual depreciation of rupee at the end of a six-month period would have no effect on the new rolled-over contract.

However in a bid to make balance sheets of market participants more transparent, the practice of rolling over forex forward contracts at historic rates was discontinued with effect from January 1995.

Now, corporates every six month have to book profit or loss depending upon the actual depreciation or appreciation of rupee and the new contract is entered into at prevailing rates rather than historic rates. Corporates found this change rather harsh and the utility and usage of roll-over contracts has greatly reduced.

Thus to provide an alternative to roll-over contracts, the RBI has permitted offering of long-term forward covers hitherto restricted to six-months. Further banks can also take open positions by offering buyers of forward covers a long-term contract without having a corresponding sell transaction against the deal. The forex risk in such case will be borne by the transacting bank. In essence, banks can, now, do market making by offering two-way quotes of such covers which was not permitted earlier.

Wither long term supply?

However, this is not going to be a great help for the growth of an active and efficient forex market. For offering two-way quotes, you need to have, buy as well as sell orders. Since the realisation and payment of exports and imports is restricted to six months, all sellers of forward dollars are limited to this tenor.

On the buyers side, banks with FCNR(B) deposits need forward covers of upto three years. Financial institutions and corporates having long-term borrowing seek forward cover for even longer tenures. Unless RBI extend export receivables realisation period to one year or more , there is not much scope for the long -term forward cover market says J.Moses Harding, assistant vice president, IndusInd bank.

One suggestion is that the RBI can permit exporters to sell their future sales in advance which is not permitted now for the growth of the long-term forward cover market. This permission can be subject to their previous years performances. Further this would help exporters in reducing their risk as they would know their revenue or sales realisation in two or three years in advance.

Alternatively, corporates should be allowed to take position on foreign currency against their rupee borrowings. This means that if a corporate has borrowed rupees in the domestic market at 18 per cent for three years, then let him sell dollar three years forward, say, at 12 per cent premium. This translates into net six per cent borrowing cost. Now the corporate runs the risk of rupee depreciation vis-a-vis dollar and in effect has converted its rupee borrowing into dollar borrowing without raising money from the international market. This on-shore shifting of liability is not capital convertibility as it does into involve actual foreign currency borrowing and at the same time it would provide liquidity to the long-term forward cover market. says a dealer at Deutsche bank.

Though banks can themselves take position on long-term forward covers and provide buyers such hedges but their position-taking capacity is restricted by the open position limits imposed by the RBI.

Even if the permitted open limits of all banks are added, a deal of $ 200 million can be hardly pieced together. And this would be consumed by only one transaction of a financial institution or a corporate borrower. This necessities the broadening of inflow of sellers of forward covers, else, many dealers think, the market will die down after a few initial deals.

However, many dealers think that ad hoc measures like permitting exporters to sell their futures sales is not a healthy way to develop the forex market. Says Shailendra Bhandari, treasurer, HDFC bank, The proper way to develop forex market is to develop the money market and nothing else is going to work. If you say let an exporter sell his future sales but at what rate? You dont have rupee-yield curve or any other basis to forecast rupee value three year hence. In the absence of any reasonable guess at interest rate differentials, exporters will be just arbitrarily demand prices.

All dealers are unanimous that the development of money market is indispensable to the growth of the forward market. Even RBI has said dealers can quote forward rates using money market factors or extrapolating existing rates.

Determining the price of two or three -year forward cover based on mere extrapolation of rates is not possible as currently the market is restricted to short-term only. And the factors influencing long-term rates are many and different than factors governing short-term rates. These factors are more related to money market.

The interest rate differential between rupee and dollar should be the forward rate but due to lack of integration between the money and the forex markets, forward premiums are governed by demand and supply of foreign currencies.

Among the steps that money market participants are demanding includes removal of statutory liquidity requirements on inter-bank borrowing.

The FCNR angle

The move by RBI to allow the banks to buy hedge products on their own account should be seen in light of the permission given to the banks to on-lend their FCNR(B) funds in dollar form to their corporate clients for productive purposes.

From the banks point of view FCNR(B) funds constitute the bulk of the foreign currency denominated liabilities. The banks have been grappling with the issue related to pricing of these loans. They have the option of on-lending the dollars at either a fixed rate or at a floating rate while they themselves pay a fixed rate on the FCNR deposits. For instance if the banks decide to charge a floating rate on the dollar loans, suppose 2 per cent over six month Libor, and after some time the Libor goes down then its possible that the banks would lend at a rate which did not even cover the fixed cost of their deposits.

In the new scenario the banks can if they so desire do an interest rate swap and ensure that both their assets as well as liabilities are at a floating rate or fixed rate. However, the advantage of this freedom given to the banks is not going to be uniform across the banking sector as a whole.

For instance consider the new private sector banks. More than 50 per cent of their FCNR(B) deposits are for a period of less than six months while a major portion of the remaining funds are for a period of less than one year. Hence a major portion of their liabilities are in nature of floating rate.

However if we take the case of the public sector banks, viz.

State Bank of India, Bank of Baroda, Bank of India, the maturity pattern of FCNR deposits is different. Around 50 per cent of their FCNR deposits is for a duration of two years and above. Hence these banks would be more vulnerable to changes in the interest rate, especially the Libor.

Given that these banks have sizeable deposits and are looking forward to lending dollar funds to corporates it is expected that they could go in for hedge products.

A lot goes in building blocks, so the RBIs recent move is definitely going to help somewhat in the growth of the market. It took many years to develop six-month forward market, so the development of long-term forward cover is also going to take time.

The execution of all these measures is indispensable for the growth of an efficient and active forex market. Else, it would remain one-way market with only buyers of foreign covers and no sellers. And all position taking by banks would be based on conjectures rather than educated estimates.