How much of the dollar/rupee trading happens offshore?

How much of the dollar/rupee trading happens offshore?

The Bank for International Settlements (BIS) released the preliminary results of its triennial central bank survey on foreign exchange and derivatives market activity this month. The survey pertains to turnover in the foreign exchange market and over-the-counter interest rate derivatives markets across the globe.

From an Indian context, the survey is important because, for the first time, it includes turnover data for the dollar/rupee pair. According to the BIS survey, average daily turnover in the dollar/rupee pair stood at $36 billion in April 2010. J.R. Varma, a professor at the Indian Institute of Management, Ahmedabad, has done an interesting analysis based on this data, comparing it to the size of the forex turnover data reported by the Reserve Bank of India (RBI). He points to RBI data in his blog, which suggests that turnover in the dollar/rupee pair would at best be around $19.5 billion a day, or only around 54% of global trading in this currency pair. In other words, almost half of the dollar-rupee market appears to offshore.

While there has been a rise in the size of the non-deliverable forward (NDF) market on the Indian rupee in Singapore and Hong Kong, bankers put the size of the market at around $1-2 billion a day. One head of treasury at a private bank puts the size of the NDF market at 25% of the domestic market, which works out to $5 billion. These numbers don’t seem to match with the BIS data. BIS officials point out that some of the data is given on a “net-net" basis, which assumes elimination of double counting on both national (local) and international (cross-border) levels, whereas some other data is presented on a “net-gross" basis, which deals only with elimination on a local level. As a result, a direct comparison of the dollar/rupee turnover data and the turnover generated from Indian sales desks of banks is not possible. They suggest that a better comparison may be possible when further details on the data are available in November.

Even so, it does appear prima facie that the size of the NDF market is larger than what most people had anticipated. According to a late 2007 paper by Rajesh Chakrabarti, a professor at the Indian School of Business, “The NDF market for the Indian rupee started back in the 1990s when it provided the foreign investors in India the only avenue of hedging currency risk in the presence of severe exchange restrictions in a scenario where the rupee was expected to have a secular decline. Foreign investors would generally sell the NDF rupee contracts to hedge their underlying positions. The opposite side would typically be taken by Indian trading companies and exporters who could make arbitrage profits as they had access to both the onshore currency markets as well as dollar flows outside the country. The NDF market typically flourishes when capital controls prohibit foreign players from having unlimited access to the onshore forward market."

While some of the restrictions from the 1990s have been removed or relaxed, foreign players still don’t have unlimited access to the markets. As a result, the NDF market would continue to thrive.

On a somewhat related note, a finance ministry-appointed working group on foreign investment has recommended that policymakers should allow foreign investors in the onshore currency futures market. Its report says, “The present arrangement, where foreign investors support the non-transparent currency forward market and are blocked from using the transparent currency futures market, is an anomaly. Once again, note that the group articulated a general policy preference that the government encourages greater trade on exchanges in comparison to over-the-counter derivatives."

One of the concerns about allowing foreign investor participation in the currency futures market was that market participants need not have an underlying forex exposure in order to take a position in this market. If foreign institutional investors (FIIs) are allowed, they could take naked short positions and could put pressure on the exchange rate, on the lines of what Thailand faced during the Asian crisis. The counter-argument is that the prescribed position limits on each market participant will prevent any run on the exchange rate and that in any case the size of currency futures market is less than one-sixth of the total dollar/rupee market. Besides, the currency futures market is cash settled, which acts as a further defence against a run on the exchange rate.

But even if there is a concern that FIIs could take a concerted view and this could put pressure on the exchange rate, policymakers could still allow them in the market with the same stipulation that they need to have an underlying exposure. As the finance ministry working group rightly points out, the policy stance should be in favour of the more transparent exchange-traded market.

Of course, this wouldn’t help in shifting NDF volumes onshore, but would remove a significant anomaly. As far as the high NDF volumes go, if indeed the size of the market is anywhere close to what the preliminary data suggests, it’s time policymakers woke up and took remedial action to stop a massive export of India’s financial markets.

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