By MV Srinivasan
The International Monetary Fund has classified India’s exchange rate regime as a ‘crawl-like’ arrangement. This means the Reserve Bank of India (RBI) is allowing a measured flexibility in the forex rate to market conditions, while still intervening to limit excess volatility, explains MV Srinivasan
What is a ‘crawl-like’ arrangement?
The IMF’s classification indicates that the RBI is allowing a measured flexibility in the exchange rate to market conditions, while still intervening to limit excess volatility. The currency is pegged to a basket of currencies, but the exchange rate is allowed to fluctuate in a steady manner, depending on economic indicators like inflation, current account deficit, forex reserves and interest rate differentials. This is a regime between a rigid fixed rate and a fully freely floating rate — rather, a managed float. The RBI intervenes in case of excess volatility or lack of liquidity in the currency markets.
This will allow the rupee more flexibility to market forces while providing a reasonable degree of stability. The IMF’s decision will not change the course of RBI’s forex rate management. It is a kind of advisory to investors that the RBI has moved to a managed peg system. However, investors would need to be cautious and hedge their exposures as the RBI would allow some amount of forex volatility. In short, the RBI does not guide a rigidly stable exchange rate.
RBI’s currency management strategy over the years
Peg to the pound (GBP) until 1946: It was changed after the formation of IMF in 1944 as the US dollar gained importance.
Peg to US dollar (USD) until 1975: After the Brettonwoods Agreement, the USD obtained the status of a global reserve currency. However, in March 1973, the US abandoned its currency peg to gold and allowed it to float. Consequently, the RBI moved to a unified rate linked to a basket of currencies.
Partial convertibility in 1992: Also called the Dual Exchange Rate Management System. Alongside, the RBI announced the Liberalised Exchange Rate Management System. The Unified Exchange Rate System was introduced in March 1993 and the rupee was freely floating within a framework of exchange control. Since then, the rupee had steadily depreciated.
Full convertibility in August 1994: The rupee was made fully convertible in the current account as per Article VIII of the Agreement of the IMF.
What are the channels through which the RBI sells dollars in the market?
The RBI intervenes in the foreign exchange markets through three channels. First, the central bank sells dollars directly through public sector banks who act as the RBI’s proxies. Large banks such as State Bank of India (SBI) and Canara Bank act as the RBI’s proxies in the currency markets.
Second, the RBI can also intervene through the currency futures market. Third and final, the central bank has nowadays started intervening through the Non Deliverable Forwards (NDF) markets.
How does the NDF market work?
Non Deliverable Forwards (NDF) markets are used to trade in currencies that are not freely convertible, using a cash settled agreement instead of physical currency delivery. Very often, there are differences in the forward rates between the onshore and the offshore markets which are exploited by participants.
Depending on the prevailing rates, two parties agree on a future exchange rate for a specific amount of a currency, for an agreed future maturity. On the maturity date, the difference between the contracted rate and the then prevailing spot rate is settled in a convertible currency of their choice.
This market is largely consisting of speculators who play to capture arbitrate opportunities, and at the same time is used by some global companies to hedge their currency risks, without accessing the domestic markets. Nowadays, the RBI intervenes in the NDF markets to calm down speculators.
What has been the trend in forward premia?
The forward discounts for the Indian rupee are based on interest rate differentials between the domestic markets and the quoted currency. Forward premia decline if the interest rate differentials narrow and widen when the interest rate differentials widen.
Occasionally, the demand and the supply of the dollar also determine the forward premia. There have been occasions when the near-term rates fell into negative territory due to cash dollar shortage. Typically, during the year end, money markets tend to be tight and the cash-to-spot premia rates shoot up substantially.
Over the past ten years, beginning April 2015, the forward premia has declined from 7.5% annualised rate to 2.5% annualised rate at present.
The writer is vice president, Mecklai Financial Services