Can RBI tame rupee speculation?

The Reserve Bank of India’s recent annual report had every analyst’s antenna buzzing with two intriguing sections. One dealt with exchange traded currency futures and the other with offshore Non-Deliverable Forward (NDF) market for rupee.

The central bank has painstakingly attempted to establish that speculation in exchange traded rupee futures causes volatility and that in periods when the currency is depreciating, the NDF market tends to exert influence on the price of rupee in onshore domestic market.

There could be two motives behind these explanations. The first could be to explain the RBI’s rationale behind the recent moves to curb speculative activity in the foreign exchange market. The other more significant object seems to be to explain why, despite all its measures, the rupee continues to run amok.

There is no disputing the fact that the RBI has a tough fight on its hands, curbing the volatility in all the three rupee markets – the inter-bank spot and forward market, exchange traded currency futures and options market, and the offshore NDF market for the rupee. The task is made more difficult by the inter-linkage or the price transmission between these markets.

While the central bank can curb speculation in inter-bank and exchange traded futures market, partially, this is next to impossible in the NDF market. Recent movement in rupee prices also shows that prices in these divisions continue to affect each other despite the central bank’s moves to reduce price transmission.

War against speculation

Curbing speculation in the domestic inter-bank market is not so difficult, since the participants are banks and foreign exchange dealers. A series of restrictions were placed on banks in 2012 to reduce their speculative forex positions. The war continued this year, with the central bank tightening liquidity to reduce speculative activity by banks. The central bank has also been trying to reduce the linkage between the three segments. Last year, it ruled that forex positions of banks in exchange traded currency instruments and positions in inter-bank forward market cannot be offset against each other. The move, in asking banks not to trade on their proprietary account (for their own profits) in exchange traded futures and options, is also aimed at reducing the price transmission between NDF and exchange traded futures market.

A paper published for the Reserve Bank of India by Harendra Behera in 2010 suggests that the extent of influence of the NDF market on onshore market has increased after introduction of currency futures in India. This could be due to banks and companies with international presence using the currency futures to play the price arbitrage.

Rupee NDF market

The task of controlling the rupee movement in the NDF market is, however, not possible. The growth of the non-deliverable forward market is linked to the opening of emerging market economies in early 1990s when global funds started investing in these countries. Lack of a mature market for hedging foreign exchange volatility in some countries and restrictions in some countries on participation of non-residents in the forward market (such as India) led to banks located in offshore destinations such as — Singapore, Hong Kong, Japan, London or New York — offering hedging instruments that were settled in cash. The currencies traded are mainly Eastern European, Latin American or Asian currencies.

According to the RBI, despite onshore financial institutions not being allowed to transact in NDF market, they are allowed specific open positions and gap limits for their forex exposure that allows them to participate in NDF market. Foreign banks and Indian companies with international presence can also trade across markets helping in price transmission. According to HSBC Global Research, towards the end of 2011, the size of the NDF market was about a quarter of the onshore market.

Attacking arbitrageurs

The central bank’s moves in the recent past appear aimed at putting an end to the domestic leg in the arbitrage between offshore and onshore market. The RBI’s move in asking banks not to trade in currency futures and raising trading margins for currency futures for other transactions has brought arbitrage activity almost to an end. Trading volumes in currency futures and options on the National Stock Exchange declined from daily average turnover of Rs 39,000 crore in June to Rs 15,303 crore in August; down 60 per cent.

Speculative activity in inter-bank market could also have come down since the average daily turnover in this segment is down 13 per cent in July from the turnover recorded in the previous month.

Rupee untamed

But why is the rupee close to its lifetime low of 65.4 against the dollar despite all these measures? One, prices in any market will reflect the future expectation of the market participants.

While the central bank can clamp down on arbitrage activities between the three segments of the rupee market, it cannot dictate the price at which deals are done. These will continue to be under duress as long as the market players are jittery about the country’s macros and the ramifications of the tapering of bond-purchase programme of the US Federal Reserve.

Two, the NDF market has other participants besides arbitrageurs. These are hedge funds and other global investment funds mandated to make money on currency volatility, operating only in the NDF market.

These funds would be shorting (or selling) the rupee with the intention to buy it at a lower price thus weakening the rupee price in offshore market. Similar bets are being taken by the traders still trading in the exchange traded currency market. It is possible that there is still price transmission taking place between the three segments.

The moot question is whether there is any need to go after speculators. Volumes will dry up if the central bank’s war against speculators continues, thus driving up hedging costs of companies. Since the central bank is anyway incapable of influencing the section of traders operating out of the offshore centres, the entire exercise to clamp down on speculation appears futile.

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