The National Stock Exchange will launch rupee futures tomorrow. Traders, derivatives experts and many others are eagerly awaiting, and cheering the debut. A Reserve Bank of India (RBI) internal working group last November recommended these futures be introduced.
This recommendation got a boost from the draft report on financial sector reforms (Raghuram Rajan report) this April. The Rajan report backing for currency futures (proposal 14) was part of a well-thought-out package. Its set of recommendations in this context are: (a) inflation targeting as the single objective of RBI, (b) a flexible exchange rate and (c) high/full capital account convertibility, with full currency and interest rate derivative markets to hedge the associated price risks.
The above set of choices is fully consistent with the constraints imposed by the well-known impossible trinity condition. The advent of rupee futures will certainly enable exporters and importers and others to hedge currency risk, under the flexible rate.
However, in my opinion, the introduction of currency futures in India now is a mistake. Instead of dampening exchange rate volatility, futures trading may increase it, defeating the very purpose it is meant to accomplish. To most finance academics, this may come across as a naïve, or licence raj, stance on currency futures. Far from it. I strongly support most of what Milton Friedman has written, including his advocacy of flexible exchange rates as suitable for most situations.
Nevertheless, my views on forex trading and derivatives are pragmatic and eclectic, not dogmatic! Although generally a free market economist, I am not a market jihadi.
Any view on currency futures in India now should be evaluated in conjunction with related recommendations. Parts of my package are similar to the Rajan package. My proposals were first outlined in the Far Eastern Economic Review, June 2007, special currency issue featuring an interview with Nobel Laureate Robert Mundell. In “Stop the Specter of Rising Rupee” (not my chosen title), I had recommended the following package: (a) inflation control as the primary goal of RBI, (b) a “random walk band” for the rupee maintained by RBI intervention and (c) stiff controls on capital inflows so that RBI reserves are enough to maintain the band.
While a flexible exchange rate is needed to ensure domestic policy autonomy, the huge swings that do occur under a fully floating rate are damaging. Experience with fully floating rates, despite full hedging facilities, shows that the “fear of floating” is amply justified.
The idea behind the random walk band is straightforward — try to ensure flexibility without volatility. RBI should take the last period’s (say calendar quarter) exchange rate as the target and allow the rupee to vary within a range, say + or -1% of the target, intervening beyond that. When the period ends, it should change the target to some average value of the last period. Over time, let the market decide.
Details and caveats for this proposal are spelt out in my paper “Rule Based Intervention to Reduce Rupee Volatility”, Icrier (Indian Council for Research on International Economic Relations) -Inwent Conference New Delhi, November 2007. The proposal is general enough to be applied to other economies with broadly similar situations.
Indeed, a band for crude oil price was suggested here by our finance minister, and elsewhere, although not a random walk band. (I am not suggesting bands for commodities — that is a very complicated issue.)
For the band to work, it requires moderate to stiff controls on capital inflows. Under such controls, the rupee would move primarily in response to the demand-supply imbalance in the current account (such as oil imports, software exports). In turn, such rupee movements, by tending to rectify the current account imbalance, will benefit the whole economy. Only futures traders will lose out. Rupee movements due to the current account will not be very large or sudden. With about $300 billion in forex reserves, RBI should be able to defend the band.
With limited rupee movement under the band, the latent demand for forward and futures contracts to hedge exchange risk will be small or non-existent. Hence the negative impact of not allowing hedging will be minuscule. Currency futures may be better than the prevailing hedging through customized forward contracts, often non-transparent, that banks devise for their customers. Forwards are unavailable for individuals or small firms. Those in favour of “democratic” futures stress this point. Granted.
However, the main issue is not whether futures are better than forwards. Rather, should we not be trying to implement policies that keep rupee volatility sufficiently low, so that neither futures nor forward contracts are needed by exporters and importers, and they can focus on their business?
We are in a regime of both very high convertibility and substantial rupee pegging based on semi-secret discretion, so foreign institutional investors, etc., will not be allowed right now to trade rupee futures here. Later on they may be allowed to do so, to attract trading from the rupee non deliverable forward market in Singapore at present. Some shrewd Sorosian speculator must be now eyeing the $300 billion of forex reserves. This is dangerous. A random walk band may help prevent the resources of the relatively poor Indian public being pocketed by some hedge fund operator during some botched-up currency intervention operation.
Vivek Moorthy is a professor of economics at the Indian Institute of Management, Bangalore. Comment at firstname.lastname@example.org