Development of Forex Markets: Indian Experience
[Keynote Address by Dr.Y.V.Reddy, at the 3rd South Asian Assembly,
at Katmandu, Nepal, on September 3, 1999]

Evolution of Indian Forex-Market

Market players in forex became active in the seventies, consequent upon the collapse of Bretton Woods Agreement. However, India was somewhat insulated since stringent exchange controls prevailed and banks were required to undertake only cover operations and maintain a ‘square’ or ‘near square’ position at all times. In 1978, the RBI allowed banks to undertake intra-day trading in foreign exchange and as a consequence, the stipulation of maintaining `square' or `near square' position was to be complied with only at the close of business hours each day. This perhaps marks the beginning of forex market in India. As opportunities to make profits began to emerge, the major banks started quoting two-way prices against the rupee as well as in cross currencies and gradually, trading volumes began to increase. During the period, 1975-92 the exchange rate regime in India was characterised by daily announcement by the RBI of its buying and selling rates to Authorised Dealers (ADs) for merchant transactions. Given the then prevalent RBI’s obligation to buy and sell unlimited amounts of the intervention currency arising from the banks’ merchant purchases, its quotes for buying/selling effectively became the fulcrum around which the market was operated. The RBI performed a market-clearing role on a day-to-day basis, which naturally introduced some variability in the size of reserves. Incidentally, certain categories of current and capital account transactions on behalf of the Government were directly routed through the reserves account.

The recommendations of the High Level Committee on Balance of Payments (Chairman: Shri C. Rangarajan) provided the basic framework for policy changes in external sector, encompassing exchange rate management and, current and capital account liberalisation. The Report indicated the transition path also. Accordingly, the Liberalised Exchange Rate Management System involving dual exchange rate system was instituted in March 1992, no doubt, in conjunction with other measures of liberalisation in the areas of trade, industry and foreign investment. The dual exchange rate system was essentially a transitional stage leading to the ultimate convergence of the dual rates made effective from March 1, 1993. This unification of exchange rates brought about the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It also marks an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

The appointment of a 14 member Expert Group on Foreign Exchange (Sodhani Committee) in November 1994 was a follow up step to the above measures, for the development of the foreign exchange market in India. The Group studied the market in great detail and in its Report of June, 1995 came up with far-reaching recommendations to develop, deepen and widen the forex market as also to introduce various products, ensure risk management and enable efficiency in the forex market by removing restrictions, introducing new products and tightening internal control and risk management systems.

The Sodhani Committee had made 33 recommendations and of these, 25 recommendations called for action on the part of the RBI. RBI has accepted and implemented in full or to some degree, 20 out of the 25 recommendations. In the process, the banks have been accorded significant initiative and freedom to participate in the forex market. These include: freedom to fix net overnight position limit and gap limits although RBI is formally approving these limits, replacing the system of across-the board or RBI prescribed limits; freedom to initiate trading position in the overseas markets; freedom to borrow or invest funds in the overseas markets (up to 15 per cent of Tier I Capital unless otherwise approved); freedom to determine the interest rates (subject to a ceiling) and maturity period of Foreign Currency Non-Resident (FCNR) deposits (not exceeding three years); exempting inter-bank borrowings from statutory pre-emptions (subject to minimum statutory requirement of 3 per cent and 25 per cent in respect of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) for the total net liabilities respectively); and freedom to use derivative products for asset-liability management.

Corporates also have been accorded noticeable freedom to operate in the forex market. Thus, they are permitted to hedge anticipated exposures though this facility has been temporarily suspended after the Asian crisis. Exchange Earners Foreign Currency (EEFC) account eligibility has been increased and the permissible end-uses widened. They were given freedom to cancel and rebook forward contracts, though currently due to the Asian crisis effect, freedom to rebook cancelled contracts is suspended while rollover is permissible. Banks can, however, offer cross-currency options on back-to-back basis. Corporates can also avail of lower cost option strategies like range forwards and ratio range forwards and others as long as they do not end up as net writers of options. Also available are some degrees of freedom to manage exposures in External Commercial Borrowings without having to approach authorities for hedging permission, and to access swaps with rupee as one of the currencies to hedge longer term exposures.

The Committee recognised that improvements in internal controls and market strategies go hand in hand with liberalisation and towards this end, RBI accepted and implemented several suggestions of the Sodhani Committee. These include: revamping internal control guidelines of the RBI to banks and making them available to corporates as well; putting in place appropriate market intervention strategies to deal with market developments; adopting internationally accepted documentation standards; framing comprehensive risk management guidelines for banks; adopting Basle Committee norms for computing foreign exchange position limits and recommending capital backing for open positions; and setting up a foreign exchange market committee to discuss market issues and suggest solutions. Recommendation on publishing critical data on forex transactions, has been implemented, and in fact the standards of disclosure by RBI are considered to be very high now.

A few recommendations of the Sodhani Committee which have not been implemented include, inducting Development Financial Institutions (DFIs) as full-fledged Authorised Dealers (ADs), setting up a forex clearing house, legally recognising netting of settlements, permitting corporates to undertake margin trading and setting up of off-shore banking units in Mumbai. Let me briefly dwell on each of these issues. Induction of DFIs as full-fledged ADs is linked to future role of development financial institutions and indeed the approach to universal banking. Till then, their activity in the forex market can only be incidental to what they are permitted to do as a DFI. The position on setting up of a Forex Clearing House and the position on setting up of off-shore banking units will be detailed in the latter part of this address. Margin trading by its very nature is considered to be potentially speculative, and therefore, has not been seriously considered so far for implementation.

Tarapore Committee on Capital Account Convertibility, 1997, had recommended a number of measures relating to financial markets, especially forex markets. Some of the measures undertaken in regard to forex may fall short of the indicative quantitative limits given in the Report, but the purpose and the spirit of such measures are in line with the recommendations of the committee. Among such various liberalisation measures undertaken are those relating to foreign direct investment, portfolio investment, investment in Joint Ventures/wholly owned subsidiaries abroad, project exports, opening of Indian corporate offices abroad, raising of EEFC entitlement to 50 per cent, forfaiting, allowing acceptance credit for exports, allowing FIIs to cover forward their exposures in debt and part of their exposures in equity market, etc. In respect of the recommendations of the Committee to develop financial markets also, significant progress has been made. In the money market, as part of improving the risk management, recently, guidelines for interest rate swaps and FRAs have been issued to facilitate hedging of interest rate risks and orderly development of the fixed income derivatives market. Measures have also been undertaken to further develop the Government securities market. Permission has also been given to banks fulfilling certain criteria to import gold for domestic sale. As will be explained later in this address, this aspect of gold policy is a major step in bringing off-market forex transactions into forex markets by officialising import of gold. Efforts are also underway to expedite the implementation of the announcement made in October 1997 by RBI to permit SEBI registered Indian fund managers including Mutual Funds to invest in overseas markets subject to SEBI guidelines.

There are several features of Indian forex market which, are briefly stated as under.

The foreign exchange market in India comprises of customers, Authorised Dealers (ADs) in foreign exchange and Reserve Bank of India. The ADs are essentially banks authorised by RBI to do foreign exchange business. Major public sector units, corporates and other business entities with foreign exchange exposure, access the foreign exchange market through the intermediation of ADs. The foreign exchange market operates from major centres - Mumbai, Delhi, Calcutta, Chennai, Bangalore, Kochi and Ahmedabad, with Mumbai accounting for the major portion of the transactions. Foreign Exchange Dealers Association of India (FEDAI) plays an important role in the forex market as it sets the ground rules for fixation of commissions and other charges and also involves itself in matters of mutual interest of the Authorised Dealers. The customer segment is dominated by Indian Oil Corporation and certain other large public sector units like Oil and Natural Gas Commission, Bharat Heavy Electricals Limited, Steel Authority of India Limited, Maruti Udyog and also Government of India (for defence and civil debt service) on the one hand and large private sector corporates like Reliance Group, Tata Group, Larsen and Tubro, etc., on the other. Of late, the Foreign Institutional Investors (FIIs) have emerged as a major component in the foreign exchange market and they do account for noticeable activity in the market.

The foreign exchange market can be classified into two segments. The merchant segment consists of the transactions put through by customers to meet their transaction needs of acquiring/offloading foreign exchange, and inter-bank segment encompassing transactions between banks. At present, there are over 100 ADs operating in the foreign exchange market. The banks deal among themselves directly or through foreign exchange brokers. The inter-bank segment of the forex market is dominated by few large Indian banks with State Bank of India (SBI) accounting for a large portion of turnover, and a few foreign banks with benefit of significant international experience.

In the inter-bank market, SBI along with a few other banks may be considered as the market-makers, i.e., banks which are always ready to quote two-way prices both in the spot and swap segments. The market makers are expected to make a good price with narrow spreads both in the spot and the swap segments. The efficiency and liquidity of a market are often gauged in terms of bid-offer spreads. Wide spreads are an indication of an illiquid market or a one way market or a nervous condition in the market. In India, the normal spot market quote has a spread of 0.5 to one paisa, while the swap quotes are available at 2 to 4 paise spread. At times of volatility, the spread widens to 5 to 10 paise.

The turnover in the Indian forex market has been increasing over the years. The average daily gross turnover in the dollar-rupee segment of the Indian forex market (merchant plus inter-bank) was in the vicinity of US $ 3.0 billion during 1998-99. The daily turnover in the merchant segment of the dollar-rupee segment of foreign exchange market was US $ 0.7 billion, while turnover in the inter-bank segment was US $ 2.3 billion. Looking at the data from the angle of spot and forward market, the data reveals that the average daily turnover in the spot market was around US $ 1.2 billion and in the forward and swap market the daily turnover was US$ 1.8 billion during 1998-99.

The forward market in our country is active up to six months where two way quotes are available. As a result of the initiatives of the RBI, the maturity profile has since recently elongated and there are quotes available up to one year. In India, the link between the forward premia and interest rate differential seems to work largely through leads and lags. Importers and exporters do influence the forward markets through availment of/grant of credit to overseas parties. Importers can move between sight payment and 180 days usance and will do so depending on the overseas interest rate, local interest rate and views on the future spot rate. Similarly, importers can move between rupee credit and foreign currency credit. Also, the decision, to hedge or not to hedge exposure depending on expectations and forward premia, itself affects the forward premia as also the spot rate. Exporters can also delay payments or receive funds earlier, subject to conditions on repatriation and surrender, depending upon the interest on rupee credit, the premia and interest rate overseas. Similarly, decision to draw bills on sight/usance basis is influenced by spot market expectations and domestic interest rates. The freedom to avail of pre/post-shipment credit in forex and switch between rupee and foreign currency credit has also integrated the money and forex markets. Further, banks were allowed to grant foreign currency loans out of FCNR (B) liabilities and this too facilitated integration as such foreign currency demarcated loans did not have any use restriction. The integration is also achieved through banks swapping/unswapping FCNR (B) deposits. If the liquidity is considerable and call rates are easy, banks consider deployment either in forex, government or money/repo market. This decision also affects the premia. Gradually, with the opening up of the capital account, the forward premia is getting aligned with the interest rate differential. However, the fact remains that free movement in capital account is only a necessary condition for full development of forward and other forex derivatives market. The sufficient condition is provided by a deep and liquid money market with a well-defined yield curve in place. Developing a well integrated, consistent and meaningful yield curve requires considerable market development in terms of both volume and liquidity in various time and market segments. No doubt, the integration between the domestic market and the overseas market operates more often through the forward market. This integration is facilitated now by allowing ADs to borrow from their overseas offices/correspondents and invest funds in overseas money market up to the same amount.

The RBI publishes daily data on exchange rates, forward premia, foreign exchange turnover etc. in the Weekly Statistical Supplement (WSS) of the RBI Bulletin with a lag of one week. The movement in foreign exchange reserves of the RBI on a weekly basis are furnished in the same publication. The RBI also publishes data on Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER), RBI's purchases and sales in the foreign exchange market along with outstanding forward liabilities on reserves etc. in the monthly RBI Bulletin with a time lag of one month. Since July 1998, the Reserve Bank of India started publishing the 5-country trade based NEER and REER in addition to 36-country NEER and REER in the RBI Bulletin. Way ahead of many developing and industrial country central banks, the RBI has been publishing the size of its gross intervention (purchase and sale) each month and its net forward liability position.