Step out of the way
Indian Express, 13th June 2012
RBI should let firms manage their currency risks, given the rupee's volatility
The rupee has shown a sharp increase in volatility. It is important for mechanisms to be created so that the Indian economy is more resilient in a world of greater uncertainty, and learns to live with higher volatility. The government must urgently expand the instruments available for firms to hedge their currency exposure.
For those of us who grew up in a controlled economy, it was felt that the RBI would manage the rupee. That age is now behind us. The RBI is largely a spectator of the price that is formed on the market. The rupee's volatility reflects this new reality. The currency options market gives us a measure of what the market expects in terms of future fluctuations. Starting from today's value of 55.91, the market seems to believe that on a one-month horizon, there is a 95 per cent chance that the exchange rate will lie between 52.2 and 59.9. This is a pretty wide range of values, and, with a 5 per cent chance, it will go beyond this range.
Businesses face currency risk when they produce any good that is tradable, even if not actually imported or exported by the firm, or have foreign assets or liabilities. But, located in the mindset that firms should hedge only those exposures that arise from exporting, importing or foreign borrowing, the government's policies on currency risk management have not kept pace with the increasing globalisation of Indian firms. An array of restrictions hold back (a) the flexibility of corporations in reducing their risks and (b) the capability of the currency market in offering protection to corporations.
Corporations are in serious trouble today because our past policies have focused on providing low volatility of the currency and not prepared them for higher rupee flexibility. Nor does the policy framework allow firms to handle rupee volatility well. On one hand, the RBI has rightly got out of trading on the currency market, and the rupee has become much more flexible. As a consequence, rupee volatility has risen, and the rupee is a bigger source of risk for many Indian firms. But on the other hand, the RBI interferes with the things that corporations can do to reduce their risk. In addition, the RBI has prevented the emergence of a capable currency derivatives market, through which this risk can be managed by the corporations. Both elements of this strategy need to be corrected urgently.
The first problem is created by the RBI's rules about currency hedging on the OTC (over the counter) currency derivatives market that operates through banks. Rules for participation in this market envision corporations hedging against currency fluctuations when exposure arises through imports, exports or foreign borrowing. This is an obsolete view of the world. Currency exposure comes about in many other ways as well. A firm that buys copper in India, from an Indian seller, is exposed to currency risk because the local price of copper is the world price of copper times the rupee/dollar exchange rate. Similarly, Indian firms that have done FDI overseas are exposed to an array of new risks. This policy should be changed and we should permit corporations to trade on currency derivatives under the aegis of a board-approved risk management policy.
The second is problem related to the emergence of a well developed currency derivatives market. The OTC market is opaque as prices are not known to all. Contract sizes are large, the market operates only through banks, and as mentioned above, there are rules about who can participate and by how much. In contrast, the exchange-traded market for currency derivatives works through the stock exchange where all Indians can participate, prices can be seen on the trading screen and contract size is much smaller, and the market is much more transparent. The focus of policymakers should be to help develop this market.
But the latter is regulated by SEBI and growth of this market would mean loss of turf for the RBI. Perhaps that is why the RBI has come up with an array of restrictions to prevent this market from succeeding. These restrictions include: preventing foreigners from participating in this market, preventing corporations from taking large positions on the market, discouraging banks from trading on this market, and so on. Finally, the RBI restricts the range of products that can be traded on the exchange. Options on the rupee-euro rate are prohibited; futures on the rupee-yuan rate are prohibited; currency swaps are prohibited, and so on. The growth of this market is not allowed. In today's volatile environment, all efforts must be made to expand the options firms have for managing their currency risk. In order to do so, existing restrictions on trading of currency derivatives should be removed. The government must step in to prevent RBI from restricting the development of markets that would allow firms to hedge their exposures.
The bulk of trading in the rupee now takes place outside India, largely owing to the restrictions imposed by the RBI. The RBI's approach has been to pretend that the overseas market does not exist. In addition, it has interfered with the trading or arbitrage which connects up the onshore market and the offshore market. All restrictions against use of the overseas market should be removed. Indian users of the currency market should be fully free to pursue their best interests, without interference from the RBI.
Businesses are surprised at the present flexibility of exchange rate, in which the RBI appears unable to prevent high rupee volatility. The path to making India more resilient no longer lies in the RBI trying to return to the old world where the market was small, and the RBI could prevent sharp rupee movements - it lies in large-scale, enterprise-level currency hedging. Financial markets and financial firms should be able to perform these services for corporations. Efforts by the RBI that restrict the emergence of a sophisticated financial system need to be reversed in order to give firms the tools that they require to protect themselves against greater volatility they face today.