The rupee has hit 50 to a dollar. That’s proof that, by and large, RBI has done well by allowing the rupee to move. If RBI had tried to delay rupee depreciation from Rs 45 to Rs 50 a dollar, this would have unleashed the sale of assets by locals and foreigners trying to take money out of the country at an advantageous rate. Both the stock markets and the currency in India look well-balanced: there is no one-way bet. Bottom fishers are already visible, trying to buy assets at these low prices. While RBI has broadly done the right things on currency flexibility, there are several areas of currency policy that require urgent attention. First and foremost is the problem of non-transparency. Everybody has seen the sharp drop in reserves. In October, reserves dropped by $33 billion. In August, reserves dropped by $10 billion (but RBI bought $1.2 billion). In September, reserves dropped by $9 billion (but RBI sold $3.8 billion). In October, reserves dropped by $33 billion. But data for RBI’s trading has not yet been released. RBI’s non-transparency is now a major source of jitteriness in the market. A programme of transparency is urgently required. RBI must match the transparency of FIIs by giving out daily data for spot and derivatives trading. In addition, full details of the currency composition, and revaluation effects, of the reserves portfolio should be disclosed daily.
The next problem is that of dollar liquidity. As long as global credit markets are malfunctioning, there is a shortage of dollar liquidity. Some of RBI’s hoard can be productively used to assist Indian firms in this regard. But stealthy trading on the currency market is a sub-optimal way to do this. When RBI trades on the currency market, this is non-transparent. The quantities and prices become unpredictable. This increases nervousness. The better path for RBI is to announce beforehand a strategy of selling, say, $1 billion every fortnight through a public auction. This programme should remain in place until credit conditions in London markets stabilise. Through this, RBI would be augmenting dollar liquidity. But at the same time, RBI would not be a source of risk in the market. A programme of this nature is open and transparent; it supplies dollar liquidity with the minimal impact on prices. This is in contrast with the method of stealthy trading, which is akin to actions of a market manipulator, increases macroeconomic uncertainty and generates currency volatility.
Future of futures
The third area of work lies in currency hedging. Many Indian firms are borrowing in India in order to meet dollar obligations. When they do this, currency mismatches are likely to build up. These currency mismatches can bring the companies or the country to grief at a later stage. How can the private sector be encouraged to hedge, and how can their hedging be enabled? The incentives for currency hedging by the private sector are critically dependent on currency flexibility. When the currency moves, the private sector will hedge. When RBI overmanages the volatility of the exchange rate, the private sector will not hedge. When a private firm decides to hedge, it has to buy dollars at a future date. The Indian currency derivative is quite inefficient, with large deviations from fair pricing. RBI should support the functioning of this market by standing ready to buy dollars at future dates. At the same time, the price offered by RBI should be driven purely by the fair price—ie, the difference between the rupee interest rate and the dollar interest rate. By using the fair price, RBI would be enabling hedging. The currency futures trading screens at NSE are an ideal mechanism through which RBI can place orders every day to buy dollars at all future dates from one month to one year out, at transparent prices.
In addition, the capacity of the currency derivatives market to solve hedging problems of the private sector needs to be dramatically increased. This requires ending the three sets of constraints on exchange-traded currency derivatives: the ban on trading in currency pairs other than the rupee-dollar rate, trading in instruments other than futures and trading by FIIs and NRIs. Bigger position limits are also required to enable corporate customers. India is making good progress in growing out of the central-planning approach of yesteryears, where RBI conducted active market manipulation. Growing up to a freer exchange rate is an essential pillar of becoming a mature market economy. The three lines of work sketched above—transparency, supplying dollar liquidity without distorting the price, and enabling currency hedging—are the next reforms the rupee requires.