Column: Fear of convertibility

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Published: April 21, 2015 12:22:36 AM

The time is right for RBI to permit non-bank financial institutions to access the domestic dollar/rupee market

RBI Governor Raghuram Rajan’s comment that he believes India should move towards capital account convertibility, which was echoed a day or so later by minister of state for finance, Jayant Sinha, has triggered alarm in certain journalistic circles. This alarm shows, surprisingly, that

a) there are still some people who don’t know we are in 2015; the fear that everybody will convert their rupees into dollars at the first opportunity is completely unfounded; the facts show that most people—Indians and foreigners alike—are desperately trying to convert dollars into rupees, whether by investing in Indian debt or borrowing in dollars; and,

b) people don’t understand that capital account convertibility is not a button you push and, poof! there you are; rather it is an ongoing process, which everyone—including the Governor—acknowledges will take some time.

I believe it is excellent that the Governor has flagged this as a priority, not least because the domestic forex market is crying out for change. The function of any market is to enable its legitimate users—entities who need to borrow or lend money, and buy or sell foreign exchange—to conduct their businesses and manage their risk as efficiently as possible. While India’s domestic forex market was quite well developed for this purpose back in 2007, it has become much less effective in recent years (goo.gl/djAJ7K). Back in 2007, the domestic Indian forex market was one of the most advanced amongst emerging markets. In terms of market liquidity—total daily volume divided by the volume of trade—it ranked third (behind Russia and South Africa) out of 15 markets we studied. It ranked even higher—second behind Russia and just ahead of South Africa—on a more sophisticated market maturity index we constructed. Fast forward to 2013, and the BIS data tell a completely different story. Onshore OTC dollar/rupee liquidity had shrunk, relative to trade, by over 50%. The ratio of daily dollar/rupee volume to trade in 2013 was at 9.6, as opposed to 22.5 in 2007; fully liquid markets, like the US, enjoyed a ratio of over 65.

In absolute terms, too, and despite the fact that global forex market liquidity increased by around 50% (from $3.3 to $5.3 trillion a day), onshore dollar/rupee trading volumes fell from $34 billion to a bit under $30 billion a day, a decline of 12.5%. Poorer liquidity makes it difficult for users to get good prices.

What is worse, the limited market participation results in definitive one-way trending markets, which makes risk management extremely difficult for users. Equally, it confounds RBI’s efforts to manage liquidity and interest rates. When there is a surge of inflows—as in January and February of this year—RBI has to buy dollars like gangbusters to prevent excessive competitiveness-busting appreciation, with consequent issues with liquidity; on the contrary, if and when there are strong outflows, RBI has to sell (dollars) like there is no tomorrow to prevent unsettling the rupee cart, generating fears of systemic risk as Indian corporates—quite sensibly, given the market—keep a significant part of their liabilities in unhedged dollars.

Digging deeper into the BIS numbers, we see that in the global FX market, non-bank financial institutions (NBFCs, mutual funds, hedge funds, insurance companies, primary dealers) generate nearly 52% of market volumes; this is nearly 30% more than that provided by banks. In the domestic dollar/rupee market, non-bank entities make up just 26% of market volumes, less than half the volumes generated by banks.

It seems to me the time is right—indeed, overdue—for RBI to permit non-bank financial institutions to access the domestic dollar/rupee market, even though they don’t have any underlying FX exposures. This is clearly a step towards capital account convertibility and should be initiated in a calibrated manner—say, by first permitting selected institutions to take maximum exposures equal to total bank volumes.

This would add about $10 billion to daily turnover and, more important, would introduce a diversity of players and views, which could help in reducing the one-way character of the market. Further, since this would also increase the average volatility, it would certainly lead to greater hedging by corporates, who would surely increase their hedge ratios if the rupee moved between, say, 60 and 67 over three months, rather than, as currently, between 61 and 63.

Multiple birds with one stone!

The author is CEO of Mecklai Financial

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