The Hindu Business Line : RBI's MIFOR move spurs... <br> Search for floating rupee benchmarks

IN THE 1990s, one of the major points of discussion about the financial markets in India was the absence of a term inter-bank market in local currency. That is, the non-existence of a market where banks can borrow and lend rupees among themselves for longer than a fortnight.

Financial market participants had in mind the international London market (the LIBOR) or the Euro market and also the various domestic money markets where this inter-bank activity was prevalent and established — for instance, FIBOR in Frankfurt, PIBOR in Paris, and so on.

Completing the circle, or providing the link between the international money market and the domestic money markets, was the FX market. It was clear that development in one — say, the domestic money market — would impinge on the development of the FX market, and vice-versa.

Foundation for swaps

Going beyond the link with the FX market, the significance of an inter-bank term money market lay in the fact that these term rates are the pre-requisites and foundation for the development of interest rate markets broadly.

It could, for example, make it conducive for borrowers and lenders to finance/lend on a floating rate basis rather than be tied to fixed interest rates.

Borrowing on a fixed rate basis and lending on a floating rate basis, or vice-versa, in turn, would provide the essential underpinning for an interest rate swap market.

In the currency area, borrowing in one currency and lending in another would, in turn, set the foundation for a currency swap market.

The advent of MIFOR

Towards the close of the1990s, the issue of a non-existent term rupee market seemed to recede into the background.

A synthetic term rupee rate — based on US dollar interest rates and the cost of swapping (or converting) dollars into rupees in the local FX market — called the MIFOR (Mumbai Inter-Bank Forward Offered Rate) was manufactured.

From a swaps perspective, the MIFOR served two purposes. First, it was a floating rate — where the rate gets re-set based on movements in the US dollar LIBOR and the forward premium for the dollar.

Any swap contract based on MIFOR as the floating benchmark, therefore, implied that the counter-parties were taking a view on both the US dollar LIBOR and the dollar's forward margin against the rupee.

For an interest rate swap in rupees, having to take a call on dollar interest rates was quite something. It was only a reflection of the fact that participants in India could not take a call on anything beyond the overnight rate.

From a currency swap perspective, exchanging a fixed rate for the MIFOR basically implied that the fixed rate was the cost for the forward delivery of LIBOR and the dollar's forward premium.

That is, any market participant with term US dollar liabilities could pay the fixed rate and receive the floating rate (comprising the LIBOR and the dollar's forward premium).

In effect, such a market participant would be hedging not only his dollar interest rate risk but also the exchange rate risk into the forward maturities.

Currency risk hedging tool

It is this role of the MIFOR swap — as a currency risk-hedging tool — that has acquired quite some prominence in the recent past. And for good reason too.

The past few years have seen a great opening up of the BoP capital account for Indian borrowers to access the hard currency markets. For all these hard currency borrowers, the MIFOR swap represented an easily accessible and competitively-priced hedging tool.

Easily accessible in that it was brought down to the level of an OTC product where even medium-sized companies — with, say, a million or a couple of a million dollars in borrowings — could enter into arrangements with their bankers.

From a pricing standpoint, MIFOR swaps also have been quite competitive over the recent past. Indeed, there have been extended periods where the MIFOR swap rate has provided fully hedged foreign currency borrowings at a cost lower than would be obtainable by issuing bonds locally.

With MIFOR on the way out now...

The old issue of the absence of a term rupee market is now back in sharp focus following the Reserve Bank of India's recent directive on scrapping MIFOR as a swap benchmark.

Swap pricing critically depends on the availability of liquid floating rate benchmarks and the derivation of robust zero and forward rate curves.

It is a fact that floating rate borrowing/lending by both financial intermediaries and non-financial corporations in India is quite limited. That is, a "cash" floating rate market on the borrowing/lending side is quite small, if not non-existent.

To that extent, viewed in isolation, rupee interest rate swaps providing for floating-to-fixed and vice-versa may not be that pressing a need.

The need and significance of swaps, though, extends over a larger domain. For instance, given the large amount of long-term fixed rate residential mortgage financing that Indian banks are doing now — in some cases, close to two-thirds of all incremental lending — swaps are an obvious interest rate risk management tool.

Also important is the issue of currency risk management in Indian bank balance-sheets. A recent RBI report on the external liabilities of Indian commercial banks points out that the international liabilities of Indian banks (that is non-rupee liabilities) are almost double that of the international assets (that is non-rupee assets).

Quite plainly, foreign currency borrowings have mainly gone on to fund rupee assets. There is nothing inherently wrong in that. Only, with such currency mismatches, risk management products such as currency swaps seem an imperative need.

As this piece is being written, the RBI has clarified that MIFOR swaps could continue to be used to hedge permissible currency exposures subject to limits to be approved by the central bank.

The issue of hedging rupee interest rate exposures and the rupee floating rate benchmarks for that purpose, though, is still open.

(The author is Associate Vice-President — Treasury — ING Vysya Bank Ltd. These are his personal views and do not represent those of his employer.)

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