Critical Data Regarding Indian Foreign Exchange Market
[Extracts from Keynote address delivered by Shri Vepa Kamesam, Deputy Governor, Reserve Bank
of India at the inauguration of the 12th National Forex Assembly organised by
Forex Association of India at Goa on October 26, 2001]

Market Players in the Indian Foreign Exchange Market

The market is skewed with a handful of public-sector banks accounting for the major share of the merchant transactions and the private and foreign banks having a greater share of inter-bank business. It is conducive for healthy market development to have much larger number of players active in the market with enhanced volumes of business. The presence of increased number of players and larger volumes alone lend certainly greater depth to the forex market leading to a more efficient functioning.

Forex derivatives have not picked up sufficiently. The development of a vibrant derivatives market in India would critically depend on the growth in the rupee based derivative products, which in turn depends on a well developed and liquid forward dollar-rupee market. This would in turn require development of a deep and liquid inter-bank term money market. In this regard, making tax laws pertaining to derivatives unambiguous and liberal will go a long way in the development of an active derivative market. In our market in its present stage, the focus of reforms should be the growth of rupee-based derivatives. The RBI took a major step in this context by putting in place an Asset-Liability Management (ALM) system for the banks. But any attempt at making ALM as a catalyst for the development of more vibrant and integrated financial markets would need to recognize the following characteristics of the Indian financial system.

firstly on account of lack of centralization of treasury operations and secondly on account of the absence of a rupee yield curve across maturities. A recent article by Zagorski in the Capital Markets News published by the Federal Reserve Bank of Chicago highlights the importance transfer pricing system. To quote " without a well-implemented funds transfer pricing system the impact of interest rate risk is buried within the results of the other operating units. Thus a bank would not be able to accurately measure the profitability of either its Treasury unit or its business units, and would not precisely understand the volatility of its net interest margin".

There is also a need to put comprehensive risk management system in place. Risk management concepts, such as, value at risk (VaR) need to be developed and implemented in the Indian market. Technological upgradation in forex transactions, clearing and settlement is a pre-requisite for developing a proper risk management system. The setting up of Clearing Corporation of India is a step in this direction. The Clearing Corporation of India, in addition to government securities, will also handle inter-bank forex settlements, which will go a long way in enhancing the efficiency and security of our settlement system for government and forex securities. The objectives of the forex clearing arrangement is to provide market infrastructure to mitigate and manage settlement risks while also reducing the costs associated with these transactions. The Corporation which is planning to act as a central counterparty for effecting clearing and settlement through de facto multilateral netting is in an advanced stage of operationalisation. It is in the interest of the Authorised Dealers that they become members of the Clearing Corporation at the earliest and undertake the changes required in regard to their back office software systems to get them integrated with the CCIL system. I understand that shortly FEDAI will be organising a Seminar to help its members expedite the formalities of taking up membership of Clearing Corporation to hasten the process of implementation of the project. Reserve Bank attaches considerable significance to an early operationalisation of the forex clearing system.

In the present context, the major thrust of RBI Policies would continue to focus on the development of deep, liquid and integrated financial markets. The importance attached to the forex market would be evident from preamble to the newly enacted Foreign Exchange Management Act. One of the main objectives of the FEMA is to promote the orderly development of the foreign exchange market in India.

The first issue that would need to be addressed relates to depth and liquidity in the market particularly in the forward segment. It is well known that barring well developed markets, forward markets are rather shallow in many of the emerging countries. Why? Given the constraints in such emerging markets are there any solutions?

In most of the developing markets, liquidity is not there for maturities are not available beyond one year period. I believe that this would be the case in most of the markets where there are restrictions on capital movements. In other words, in markets dominated by trade related flows and which are not financially driven, where capital controls exist, liquidity across the spectrum as seen in the developed markets, may prove to be difficult at least in the early stages of development of the market. The question that we would need to address is within these constraints, how can the liquidity improve? Indian experience suggests that there could be two impending factors in this regard. First is the absence of a well developed local money market and second more important the reluctance of larger public sector banks who handle the major portion of the export-import transactions to assume the mantle "market makers". While the solution to the first problem partly lies with the Central Bank and there have been many initiatives in this regard as I had stated earlier, it is entirely up to the bank managements to make their banks more pro-active in the market and realise that Forex dealing rooms could be an important profit centre, provided proper risk management systems are in place. You may have a point of view that liquidity has come down after the imposition of restrictions on re-booking of cancelled contracts. While this kind of liquidity in an emerging market, which often tends to get one sided, is a debatable issue, absence of this freedom is more acceptable than wide swings in policy prescriptions whenever volatility erupts.

In the developing markets where volumes are not large, it has to be remembered that the positioning of the markets, types of players allowed entry into the market, the amount of unhedged position, all could prove crucial when turbulence erupts. The last mentioned issue that of unhedged positions of the corporates is currently attracting the attention world over. Reserve Bank would welcome and support efforts of the banks in monitoring such positions on an ongoing basis since this is closely linked to the issue of credit risk as well.

A major issue that has attracted sustained debate among the Forex market participants during the last one year, has been the issue of long term rupee – foreign currency swap. This was permitted in 1997 as a hedging mechanism for corporates who run long term foreign currency exposures. When instances of use of this product to merely take a view on the currency movements and putting in place structures that would be tantamount to corporates effecting pre payment of the foreign currency loan were noticed, banks were advised last year to put through transactions only on a fully matched basis. The matter has since been reviewed and the banks accorded limited freedom to run a swap book. We are aware that banks have been raising a few issues in this regard and demanding greater freedom to make this product a genuine hedging tool. Reserve Bank would continue to monitor transactions in this area and take pro-active decisions with a view to offering further relaxations wherever warranted.

There have been demands from the market players to be accorded greater freedom in the investment of foreign currency funds and using new products like the options to better manage their balance sheet and proprietary trading positions. Given the fact that FCNR (B) deposits are presently accepted for maturity ranging upto three years, there is justifiable demand for permitting longer tenor investment out of these funds. Reserve Bank of India is actively reviewing the current restrictions in this regard. Although options could be a very useful to any managing risk positions, particularly at the Treasurer level, there has been very limited demands from the market for using this product. Reserve Bank is open to the suggestions from the banks for using new products to help them in better managing risks

Finally, Reserve Bank is alive to the developments around us, with its epicenter in the US that could have a bearing on the Indian economy and the financial markets. Several groups within the Reserve Bank are reviewing the position in its various dimensions on an ongoing basis. Options are considered as developments unfold and expectations are formed. Actions are explored as appropriate to meet the dynamic situation. Our actions since September 11, in regard to various financial markets testify to alertness and promptness of RBI, whenever considered necessary.