On the rupee in the Financial Express,

Column: Don’t kill the messenger, read the message

Varun Khandelwal

The government and RBI have taken several measures to check the depreciation of the rupee. Both have made several references to the non-deliverable forward (NDF) markets as a source of speculative activity against the rupee.

NDFs are derivative contracts that do not require the delivery of the underlying asset. NDF markets exist for most emerging market currencies that are not freely convertible on the capital account. They allow market participants across the global to speculate freely, while remaining outside the purview of the regulatory structure of the country in question.

A thriving NDF market exists for the rupee in Hong Kong, London, New York and Singapore. According to estimates by an NDF market maker, these markets trade about $5-7 billion daily. The onshore markets, derivatives and spot, used to trade approximately $4-6 billion.

After RBI’s recent measures to curb speculation, the onshore volumes for the rupee have declined by about 50% to $2-3 billion. Effectively, the NDF markets are now responsible for about 60-70% of daily rupee trading from about 40-50% earlier. According to data from a December 2011 report by HSBC on emerging market currencies, the NDF markets had a share of only 20% in rupee trading. Clearly, offshore rupee volumes are on a rising trend.

This is a pain point for RBI. RBI has a myriad of regulations on the convertibility and trading of the rupee in India. As the entities offering NDF products are offshore, RBI’s regulations and Indian laws such as the Foreign Exchange Management Act (FEMA) do not apply.

Usually, the NDF forward prices trade 20-30 pips higher than onshore futures on the NSE. Further, the derivatives on the NSE trade at a premium to the interbank spot rates. The extent of this difference is determined by interest rate differentials and market liquidity conditions. This difference offers an arbitrage opportunity to entities that can trade both the markets.

Multinationals, foreign banks, custodians, some domestic banks, large export houses, etc, which have presence both onshore and offshore, are able to arbitrage this difference by selling the NDF and buying the futures on the NSE or, in some cases, buying the spot itself. This regulatory arbitrage trade is preferably executed using derivatives as the cash outlay is lower and leverage can be used to enhance the returns. While there exist RBI regulations to deter this sort of regulatory arbitrage by offshore subsidiaries of Indian companies, these regulations are difficult to implement in practice due to limited scope of scrutiny of offshore companies by RBI.

Instead, RBI has tried to crack down on this trading by sharply curbing domestic trading. The drastic reduction in permissible open interest on exchange traded derivatives has reduced the capacity of market participants to speculate on the rupee. It also limits the extent to which the NDF arbitrage can be carried out using the derivatives on the NSE since the domestic leg of the transaction cannot be carried out in large volumes.
Additionally, RBI raised the average daily CRR requirements, capped the liquidity under the Liquidity Adjustment Facility (LAF) and raised the spread between the Margin Standing Facility (MSF) rate and the repo rate from 100 bps to 300 bps, bringing the effective rate to 10.25%. Since RBI announced these measures, overnight call rates rose from 6-7% to about 10%, approximately the same as the MSF. Higher interest rates raise the opportunity cost of holding dollars instead of rupees. The monetary tightening created forced sellers of some domestic banks whose treasuries sold dollars to raise rupee liquidity which is now substantially more expensive and needed to fulfil stringent CRR requirements. These measures caused the rupee to appreciate by 2-3% for a short while before resuming its move down.

The monetary tightening that resulted in temporary support to the rupee will prove very costly to the Indian economy. Overnight interest rates are higher by 400 bps, there is a severe liquidity crunch in the money markets, and the stock markets have fallen about 8%, with bank stocks correcting between 20-40%. This creates a very inhospitable investment climate in India.

The reduced volume in the onshore market threatens to make the rupee more, not less, volatile. Further, these restrictions may move more rupee trading volumes offshore as market participants prefer that the rules of the marketplace are not changed to hurt them. This will move an ever larger fraction of the market outside of RBI’s jurisdiction, threatening to make the transmission of policy measures tougher.

There are strong reasons why the rupee is not stabilising. India’s poor governance, declining growth, high current account deficit, and high fiscal deficit have made the rupee the currency of choice to bet against in the emerging markets basket. Additionally, the threat of reduction of quantitative easing in the US has put all emerging market currencies and bonds under stress. RBI’s own poor communication skills add to the problem. Statements about them being “concerned with exchange rate volatility, not rupee level” invite bets against the rupee as the implication is that the central bank does not care if the rupee goes to 61, 64 or 67!

If the rupee is to be stabilised, RBI needs to communicate less often, and more effectively. Policy measures should be followed up with strong interventions in the FX markets. The central bank and the finance ministry should keep their disagreements private. The government is naive to expect the investment sentiment to improve in the face of slowing growth, looming elections, unimplemented liberalisation, inaction on industrial revival, and unbridled populism exemplified by the Food Security Bill.

The NDF markets are outside RBI’s jurisdiction, and no manner of domestic restriction will diminish their existence. Markets are messengers of underlying problems, not the cause. If drastic measures are on the table, why not temporarily ban gold imports instead of murdering the economy? Pakistan just did. Probably a ban on gold will damage perceptions more for the ‘aam aadmi’ and some mumbo-jumbo in the credit and currency markets.
The author is managing director, Bullero Capital, a Sebi-registered portfolio manager