India’s economy, for so long one of the BRIC stalwarts, appears to be at a crossroads as it faces slowing growth, rising inflation and a widening current account deficit. These underlying frailties have been exacerbated by the prospect of tapering by the U.S. Federal Reserve, sending India’s currency to an all-time low in August as risk capital headed for the exits.
Despite emergency measures by the Bank of India to stabilize the rupee (INR), confidence remains fragile. Along with questions about the growth outlook for the world’s second most populous country, a return of taper fears sent the rupee into a fresh rollercoaster ride. In addition, the policy choices facing the Indian government have also been brought into focus regarding its path for internationalizing the rupee.
To shed some light on India’s currency conundrum, we sat down with Sandra Ro, CME Group’s Executive Director of FX Research and Product Development.
What have you been seeing in terms of rupee trading during the recent market volatility?
The big change in recent months has been a surge in offshore trading of the rupee in the non-deliverable forwards market. The restrictions on the onshore market (no foreigner can hold the rupee or take it out of the country) where you have “trapped cash” has led to more trading being diverted offshore. Added to this, restrictions such as limiting trading onshore to domestic banks, as well as various taxes, are all increasingly driving trade offshore.
We are also seeing not convergence, but divergence between the onshore and offshore markets. This is the opposite of what we would hope to see for an orderly development of the market.
There has been huge volatility in the Indian rupee, falling to all-time lows in August despite making a partial rebound in September. What is driving these large swings, and do you expect volatility to continue?
There was clearly a loss of confidence in the currency as investors punished countries with weak fundamentals as tapering concerns took hold. The large move of trading offshore is a concern for INR watchers as well as the Indian government, as it suggests the offshore NDF INR market is driving pricing of the onshore INR spot market, rather than the other way around as it should be.
Trading has also mostly been driven by speculative activity rather than hedging, as investors were looking for some way to sell the rupee.
We are seeing more volume in our CME Rupee futures contract than anticipated since we launched at the end of January this year, and the ratio of ADV (average daily volume) to OI (open interest) suggests that it is mostly speculative in nature. It should be a concern to policymakers that the rupee is developing into a high beta, volatile currency and has become a proxy for the “risk on, risk off” trade.
Do you expect to see policy change to try and develop the onshore market and internationalize the rupee?
There is a demand for a greater liberalization of rupee trading, although it is less clear how India will get there. There have been discussions about the best way forward including suggestions that India should look to China’s model of developing trade settlement partners with currency swaps, or a free trade zone as potential options. There needs to be more liberalized laws to satisfy real demand for local entities as well as international entities to hedge currency risk.
As it stands, taxes on trading onshore and other restrictions mean it is a one-way street with activity moving offshore. This means, not only does India lose trade to Dubai or Singapore, but authorities also do not get oversight.
The current size of the offshore market has become problematic, especially as you get more arbitrage and speculative trading. There is also debate about how “big” the offshore market now really is. The Triennial Central Bank Survey 2013 estimated the USD/INR/ADV (all onshore/offshore spot non-deliverable forwards) is $50 billion. The risk is at some point you may get more draconian measures from authorities. Yet the BIS 2013 survey said it was difficult to assess how big the offshore market is due to a lack of transparent data.
What we want is to see is stable, liquid and transparent futures on currency pairs to serve hedging needs. We always hope that our futures contracts become deliverable as this allows markets to become international, which is the ultimate goal.
There has been some optimism that India is taking steps to address the current situation such as the appointment of a new governor at the Bank of India.
There are high hopes for the new appointee at the Bank of India, Raghuram Rajan, with his background as a former chief economist at the International Monetary Fund. In recent briefings, Rajan has indicated he is going to be proactive reforming domestic financial institutions and allowing greater foreign participation in the banking sector. In theory, this should also lay the foundation for greater liberalization of rupee trading.
His initial emergency measures to open up swap lines for oil imports, which allows state-backed oil companies to buy dollars directly from the central bank, as well curtailing gold imports, have helped reduce pressure on the balance of payments. He has also stopped onshore banks from putting on proprietary trading positions, in order to curb more of speculative behavior. Yet, overall these are mainly ‘sticking plaster’ type measures to buy some stability.
There is also a need to anchor inflation expectations, especially if we are to see a return of tapering early next year. So far Rajan has appeared quite hawkish, having raised the benchmark repo rate by 25 basis points twice since September.
What are the longer-term prospects for the India and the mood of investors?
This year has really been a rough one for not just the rupee but also Indian equities. One sign that investor confidence has been badly shaken is the share price performance of Financial Technologies, which operates a network of ten regional exchanges, including India. Its share price is down over 70 percent this year.
Longer term, it is fundamental issues such as India’s current account deficit and investment environment that will be key to repairing investor confidence and attract foreign capital. Next year is an election and that will be another focus for the market.