Trading volumes in the Indian rupee have risen close to four times between 2004 and 2007, and its share of world currency transactions has more than doubled from about 1.5% to 3.5% during the period. Much of this is driven by foreign investors? discovery of India. In the last five years, foreign investment inflows have grown at a compounded annual growth rate (CAGR) exceeding 26%. Simultaneously, Indian corporates have gone for external commercial borrowings in a big way. During 2006-07, foreign borrowings of the largest Indian companies amounted to about 30% of their domestic borrowings. Crossborder M&A activity and private equity flows to India have also zoomed.
All these crossborder investment flows, together with enhanced trade flows, create a corresponding need for hedging currency risk, particularly given that the exchange rate is more than twice as volatile in 2007 as it has been in the last few years. That?s where currency derivatives come in. Forwards, options, futures and swaps all help players better manage foreign currency risk.
Demand for currency hedging instruments for the Indian rupee is perhaps best reflected in the relative turnover volumes of forward contracts involving the currency. Forwards are the simplest of forex derivatives that involve an agreement on the price of a future purchase or sale. According to the Bank for International Settlements? triennial survey, the average forward market turnover in the rupee gently rose from 27% of that of the spot market turnover in 2001, to 31% in 2004. In 2007, the figure more than doubled to 65%.
Currency derivatives available in India today include forwards, options and swaps involving the rupee. All of these are over the counter (OTC) instruments that need to be purchased from banks, as opposed to being exchange-traded. Moreover, several stipulations apply to them. In an effort to ensure that forwards are used only for hedging purposes, resident individuals/firms and FIIs are required to provide proof of their underlying positions before they take positions in the forward market, though moves are now afoot to make things simpler for resident individuals and SMEs. This restricts the market entry of several entities with bonafide hedging needs, not to speak of speculative currency traders.
An important consequence of these restrictions has been the development of a vibrant offshore market in non-deliverable forwards (NDF) on the Indian rupee. Based primarily in Singapore and in operation since the mid-1990s, this is a market where deals are settled by paying in dollars the difference between the contracted forward price and the resulting spot price of the rupee on the settlement date. Thus no rupee transaction actually takes place, but the instrument serves as a betting device on the value of the rupee. In recent times, the NDF market has witnessed explosive growth with average transaction volumes reportedly exceeding $750 million a day in 2007, from about $100 million a day only three years ago. Most major foreign banks offer NDFs, but Indian banks are barred from doing so. The NDF market serves currency hedge funds and other offshore entities interested in speculating on India. Multinationals and foreign portfolio investors who use the P-Note route to Indian assets also use this hedging device.
Arbitrageurs?including Indian exporters?with access to both onshore and offshore forward markets help keep the rates close to one another.
In what may be a sign of the times, the first exchange-traded currency derivative on the rupee was recently launched not in India, but in Dubai. The Dubai Gold and Commodity Exchange, DGCX, which has India?s Multi-Commodity Exchange, MCX, as one of its promoters, started trading future contracts on the Indian rupee in June 2007. Futures are the market-traded counterparts of currency forwards. With standardised contract size and maturity dates, they make for a liquid hedging instrument and aid price discovery in the currency market. On January 11, the notional open interest (contracts outstanding) for Indian rupee futures at DGCX was over $5 million (101 contracts of Rs 2 million each).
The success of rupee futures in Dubai, without explicit RBI approval, points to two things: that it were regulations that held back the growth of exchange-traded currency derivatives in India, and that in today?s globalised financial environment, domestic strictures merely shift the trading overseas. This has acted as a spur for the RBI, which came up last November with its own proposals to introduce such currency futures in India, though they need to be reconciled with the Foreign Exchange Management Act. Clearly, it is impractical to require futures market participants to prove their underlying positions, as is currently required of OTC customers. Waiving it for futures while retaining it for OTC transactions may lead to regulatory arbitrage, so it?s best to dismantle the requirement altogether.
These would be welcome and perhaps inevitable developments, allowing better currency risk management practices for a burgeoning group of individuals and companies?both domestic and foreign?with rupee-related foreign exchange exposures. They would also set the stage for full-blown capital account convertibility.
The author teaches finance at the Indian School of Business, Hyderabad. These are his personal views