Get the rupee off this roller-coaster

Even as forex market participants were beginning to believe that rupee would be confined within the 55 to 57 range for a while, the currency has appreciated 5 per cent in two weeks to reach 53.4.

Sudden rallies such as these and equally sharp plunges, put the regulator as well as the other stakeholders in the forex market in a fix.

The rupee is not only one of the worst performing Asian currencies this year, it is also among the most volatile. According to Bloomberg , both historical and implied volatility priced in the rupee options is the highest among the Asian currencies.

Volatility leads to unpredictability or uncertainty that throws corporate as well as government budgets into disarray. It is, therefore, not surprising that the RBI is taking a close look at the factors causing these gyrations.

In his recent address to the annual forex assembly of the Forex Association of India, G. Padmanabhan, Executive Director, Reserve Bank of India talked about the inadequate response of companies to forex fluctuation, misuse of hedging facilities by companies and banks and the growing clout of currency futures segment.

Companies fall short

Mr Padmanabhan reiterated the central bank’s view that a volatile rupee is the ‘new normal’ and corporate India has to learn to live with it. But most companies have not made optimal use of the hedging instruments available.

Instead, they got lulled into a sense of complacency by the rupee’s extended movement between 44 and 46 in the two years from October 2009 and did not hedge risks. This has led to sharp losses.

Another point for which companies were reprimanded was misusing facilities such as past-performance-based hedging (wherein they could buy forwards based on their past imports and exports) , cancellation or rebooking of forward contracts and Exchange Earners’ Foreign Currency Account (EEFC).

Such facilities provided leeway for companies to buy forward contracts in inter-bank market without an underlying position and use it as an avenue for trading. It was also possible for companies to hold export earnings in EEFC account till the rupee reached a conducive level.

The RBI clamped down on these facilities in May, and then in August allowed partial use of these facilities on protests by various lobbies.

Banks turn naughty

The banks also share a part in contributing to the sharp gyrations in the India currency. To fulfil their function as market-makers in the interbank forex market and also in relation to their clients, they need to carry a position in forex where the rupee is one of the currencies.

But it appears that the position that many banks held was far higher than their need and seems to have been driven by the motivation to hoard in time of shortage, profiting from the price fluctuation.

The RBI had to impose limits on overnight and intra-day positions held by banks in order to check these practices. Banks were also given a rap on the knuckles for giving the small and medium enterprises a raw deal. These smaller entities do not get competitive rates for executing hedges akin to the larger companies.

This has resulted in many smaller companies deciding not to hedge forex exposure at all.

Exchange-traded futures

Mr Padmanabhan also pointed at the increasing influence of exchange-traded currency futures on the rates in the inter bank forex market.

“We can no doubt have competing market segments as competition will bring in more efficiency. But, how can the competition be fair when the playing fields are completely asymmetric?” he asks.

While positions in inter-bank market can be initiated only by companies with an underlying foreign exchange exposure, no such constraint is present in exchange-traded futures.

Again the fact that the exchange-traded futures are non-delivery based ensures that there is always a spread between the prices on exchanges and OTC market.

Banks have been making the most of the arbitrage opportunity this offers.

Towards the end of May, the RBI had stipulated that the forex positions on stock exchanges cannot be netted by undertaking positions in the inter-bank forex market and vice-versa.

This appears to have been aimed at curbing banks affecting rates in inter-bank market through exchange-traded futures.

Long-term solution?

The RBI imposing restrictions on speculation in forex market to curb volatility is in line with what regulators typically do.

Speculators are known to take prices of assets far beyond their fundamental values.

Temporary curbs on speculation can rectify such excesses, but these measures cannot be a long-term solution.

Too many restrictions on trading affects liquidity and efficient price-discovery in markets.

The average daily turnover in interbank forex market is down 24 per cent this August, compared with a year ago.

Turnover in the exchange-traded currency derivative segment is also declining this calendar. It is also a widely acknowledged that asset prices with high traded volumes are more difficult to manipulate.

Again, there is another market for rupee overseas, the Non deliverable Forwards (NDF) market that offers banks three-way arbitrage. Signals generated by that market cannot be easily curbed.

As Padmanabhan said, ‘policy response to structural as well as exogenous factors that lead to mismatch between inflows and outflows take time to yield results.’ In the meantime, the RBI’s efforts to tame the wild rupee will be interesting to watch.

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