Markets are rallying in anticipation that India is ready to embrace serious economic and financial reform. The landslide victory of the Bharatiya Janta Party (BJP) to elect new Prime Minister Narendra Modi in May’s elections points to a watershed in Indian politics.
For the first time in three decades a single party is in power with an overall majority, giving a powerful mandate to Modi’s administration and it looks as if he intends to use it. Last week, Modi set out a reformist agenda to the Indian Parliament promising to boost foreign investment, simplify tax codes as well building not just basic infrastructure but smart cities and a high-speed rail network.
While there has been a surge of optimism since the new government took office — with the Rupee strengthening and the Indian stock market making fresh highs — the in-tray for Modi will include a number of pressing problems ranging from stubborn inflation to lingering fiscal and current account deficits, to an economy growing at barely half the rate of recent years.
To successfully steer the economy on a new path, much will depend on Modi’s ability to tackle financial reform to internationalize and upgrade India’s financial system.
To get a sense of how significant the changes could be for financial markets and the Indian Rupee, we sat down with Derek Sammann, Senior Managing Director, Foreign Exchange, Metals & Options Solutions; and Malcolm Baker, Senior Director, Foreign Exchange and Interest Rate Products at CME Group.
When it comes to financial markets, what policies will potentially have the biggest impact on international investor confidence?
Derek Sammann (DS): While we are just in the first weeks of the new government, we are already seeing encouraging signs of financial liberalization.
One change I would highlight is the move to increase the access of foreign portfolio investors to trade on domestic exchange-traded currency derivative markets. At the beginning of June The Reserve Bank of India (RBI) increased the potential hedging position to up to USD10 million over and above the exposure of the portfolio investment.
While this might not be significant in its immediate impact, the direction is highly encouraging. Further guidelines are expected to also boost participation by domestic entities in the exchange-traded currency derivatives market.
This should help to boost liquidity and redirect some of the Rupee currency trading — which had migrated offshore — back onshore. It is important to bring price discovery onshore, and I think that is very powerful and healthy for the market.
Do you think there will be any policy change at the Reserve Bank of India headed by Raghuram Rajan, given Prime Minister Modi has run on a fiscally aggressive platform?
DS: I think the decision by Prime Minister Modi to keep Dr. Rajan in place at the RBI shows they have broadly similar aims. This sends a very strong signal that the reform agenda will continue.
Since taking his position in August 2013, Dr. Rajan has already stabilized India’s financial markets and is now rolling back some of these temporary measures. For example, while measures were implemented to increase imports of gold — the second largest import item after oil – to reduce pressure on the current account, the deficit is now shrinking and these are now being partially reversed.
The Indian Rupee has been through somewhat of a rollercoaster ride in the past year. What are your expectations on the currency policy at the RBI going forward?
DS: Like various other emerging market currencies, the Rupee was a victim of international capital reacting to Fed tapering last year. While Dr. Rajan remains very much an advocate of free markets, he also recognizes the risks in the U.S. Federal Reserve’s retreat from quantitative easing.
I was sitting with him on a panel earlier this year during a lively exchange between him and former Fed chairman Ben Bernanke, who was in the audience. Dr. Rajan argued that the Fed policy of quantitative easing was an artificial stimulant and not a free market practice. This meant the Fed must consider the international impact when retreating from a position of artificial stimulus. Clearly since he assumed office, India is now in a stronger position. As well as steadying the current account, the RBI has also built up a substantial foreign reserves buffer of over $312 billion.
Does the stabilization of the Rupee mean it is no longer seen as the risk-on/risk-off currency trade of choice?
Malcolm Baker (MB): I think there has been a change in the perception of the Rupee as some of the volatility in the currency has abated since May when there was a “risk-on” move after the election result.
It is encouraging to see signs of the currency stabilizing such as a narrowing in the bid/offer spread. If we roll back to a year ago there was little liquidity, especially if you moved out the curve. Today liquidity is back on our Indian Rupee contract and the pricing is tight. I think the pick-up in confidence is a big factor, which comes with there being a lot of credibility that reform is moving in the right direction.
We are also seeing a maturing in the market. We are seeing more open interest, rather than just intraday traders.
While you mention the reform steps so far are encouraging, what else would you like to see?
MB: I think that moves to encourage currency hedging onshore are very positive initial steps. But you need to encourage two-way flow of capital, both onshore and offshore. Obviously, for CME Group, we would hope to see policies that also encourage wider capital liberalization offshore.
Ultimately, to have strong capital markets, as well as capital convertibility and a freely trading currency, India also needs to develop its domestic bond market. To have properly functioning interest rate futures, you also need to build up an underlying government cash market bond market. As reported in our OpenMarkets article in April, we are encouraged that the RBI has relaxed some rules in order to encourage a more active onshore rates market, and trading appears to be picking up.
India often gets compared unfavorably when it comes to not just China’s growth performance but also its moves to liberalize its currency. How would you rate India’s efforts?
DS: It should be noted that both countries are going about liberalization in very different ways. In China, reform has been conducted offshore by encouraging the RMB to be used for trade settlement in various international destinations. India has a different kind of experiment where reform is primarily occurring onshore, through legislation. And it already has an exchange rate that is market-driven. I would say the boldness of India’s reform path is often understated and it shows that India is willing to take intelligent, calculated risks.
Can you comment on turnover on your CME Indian Rupee Futures contract?
MB: The Indian Rupee FX futures (INR/USD) have traded in excess of 188,000 lots across the Standard (INR 5 million notional) and Micro contracts (INR 1 Million notional). The take-up across multiple client segments has been very solid for a new contract. The most active segments are banks, proprietary traders and hedge funds. That being said, we have seen hedging from corporates and retail on a frequent basis. Activity generally starts around 9:30 a.m. Singapore time and stops when the market closes at 5:00 Singapore time. Currently outside the over-the-counter INR NDFs, which is open 24 hours a day, CME Group’s INR FX futures are the only global onshore or offshore venue to offer 23 hours per day liquidity. Since the frenetic emerging market “risk-off” sentiment of summer 2013, volatility has slowly ebbed away and so have trading volumes onshore and offshore. The recent Indian election provided some much-needed confidence and interest to trade INR/USD and Indian equities, and this caused CME Group FX volumes to reach their highest since September 2013.