The decision by the Reserve Bank of India (RBI) to signal the end of the easy money policy regime dominated most media coverage and commentary last week. What largely escaped attention—a discerning colleague drew my attention to it—was the fine print in RBI’s policy document that showed how it had, without much ado, moved the ball on financial sector liberalization significantly.
RBI expanded the portfolio of currency derivatives beyond the dollar and also set the stage for the introduction of the much maligned credit default swaps (CDS)—both of which are designed to bring India more on par with what is happening globally, especially given the country’s status as a trillion-dollar economy.
This is significant. Not just because of the import of the changes, but also for the fact that RBI has chosen to let its head rule the heart. All the more because bleeding heart politicians of all hues continue to wax eloquent on how it was their intervention that put the brakes on the rapid liberalization of the financial sector, and thereby shielded India from the global meltdown that started on Wall Street a little more than a year ago. Seen in this context, it is also a big step forward in underlining the central bank’s autonomy.
But first off, what are these changes and why are they significant?
A CDS allows creditors to protect against the chance that a borrower might default. This includes investors who may buy into a corporate bond issue and can then get protection against a default by purchasing a CDS. The price at which the CDS is bought is what is referred to as the spread and will vary depending on what predetermined amount of the bond value is guaranteed.
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Currency futures are derivatives that guarantee a predetermined foreign exchange rate at a future date in return for a price. This is typically useful for exporters who enter a transaction today and receive payments much later and are, therefore, vulnerable to currency movements. For example, if the rupee appreciates in the intervening period, they would end up getting paid less in rupee terms.
Ever since the meltdown happened, critics have blamed it on the lack of adequate oversight of Wall Street. (Former US president George W. Bush, while addressing the annual Hindustan Times Leadership Summit on Saturday, described it thus: “Wall Street got drunk and we had the hangover.”) That is indeed one part of the story, and something that needs to be fixed.?But such claims have also provided?ammunition for the conservatives, who always fear the unknown. While caution is prudent, exaggeration of the problem can be harmful. In fact, such was the groundswell of criticism that RBI, which had introduced draft guidelines for CDS in 2007, quietly buried them after the financial crisis broke out. It has now decided to revive its proposal and introduce simple “CDS for corporate bonds for resident entities”.
One flaw in this move is that this will be offered as an over-the-counter product, wherein traders bilaterally negotiate the price, which by its inherent nature is opaque and open to misuse, especially since not many people are going to understand the sophistication of the product in the initial period. Don’t forget the disaster that struck Indian companies last year when they purchased exotic forex derivatives over the counter—some of them are still in litigation with the banks that sold such products to them—and their bets went wrong. A more prudent solution is to enable it through stock exchanges, where the price can be fixed transparently and purely on a demand-supply basis. RBI should draw a lesson from the successful introduction of the trading of rupee-dollar futures through stock exchanges in March. The value of the daily trades on the various stock exchanges in the country has risen to $2.5 billion a day—an affirmative verdict no doubt.
In fact, RBI has in its credit policy gone a step further and expanded the menu of currency pairs beyond the rupee-dollar, to include rupee-euro, rupee-yen and rupee-pound sterling. It is indeed perplexing as to why RBI would find exchange trading good enough for one derivative and not for another—which would potentially also be by far more popular than currency futures. It may well be that RBI is being cautious. But it should remember that anything done in half measure has a bigger chance of failing.
My own sense is that there is an element of a turf battle that has caught up with an otherwise sensible policy. An exchange-traded instrument will automatically bring it under the purview of the Securities and Exchange Board of India— the markets regulator—and force RBI to cede its authority. If indeed it is the case, RBI has succumbed to the old maxim: one step forward and two steps back.
Anil Padmanabhan is a deputy managing editor of Mint and writes every week on the intersection of politics and economics. Comments are welcome at firstname.lastname@example.org