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]

Linkages among Markets and Policy Responses

Since the introduction of the reform measures, broad segments of the market, viz., money market, Government securities market, capital market, and foreign exchange market, have exhibited some degree of integration. The markets have become inter-linked to the extent participants can move freely from one market to another. The linkages between the forex market and domestic markets essentially depend on the foreign currency liabilities and assets banks can maintain and the extent and degree to which they are swapped into rupees and vice versa. Thus, on the liabilities side, we have foreign currency borrowings from overseas offices/correspondents, borrowings for lending to exporters, FCNR-B deposits and EEFC/RFC deposits. These funds can be used either for raising rupee resources through swaps or for lending in foreign currency. A significant step was taken by the RBI when it allowed banks to lend in foreign currency to companies in India for any productive purpose without linking to exports or import financing. This effectively meant that companies had the choice to borrow either in foreign currency or rupees depending on the cost, taking into account both exchange risk and interest cost. Thus, companies can substitute rupee credit for foreign credit freely. Similarly, exporters also have the ability to substitute rupee credit for foreign currency credit.

The integration of foreign exchange market with other markets like money market and government securities market meant closer co-ordination of monetary and exchange rate policy. For instance, in January 1998, when the foreign exchange market came under severe pressure, Reserve Bank of India undertook strong monetary policy measures leading to sharp withdrawal of liquidity and increase in short-term interest rates. The impact of monetary management was such that by February 1998 orderly conditions were restored in the forex market and normalcy was attained in money market. At times of highly speculative exchange rate movements, simultaneous intervention in foreign exchange and domestic market is called for to have an immediate strong effect on both the exchange rate and money market conditions. Thus, to maximise the effectiveness of the foreign exchange market intervention as a signaling device, it is also carefully co-ordinated with monetary management. These co-ordinated intervention strategies require close day-to-day monitoring of the supply of banking system liquidity and an active use of open market operations to adjust liquidity conditions. However, driving a wedge between money and forex markets at times, becomes necessary when it is felt that liquidity conditions may put pressure on the forex market, while tightening liquidity could hurt the real sector.

The recent initiatives of RBI to usher in the rupee interest rate derivatives should facilitate the development of rupee term money market and define the rupee yield curve across maturities. Besides bringing about greater integration of the money and forex markets, the move has set the stage for the take-off of rupee-foreign currency derivatives.

Liberalisation of gold policy had an indirect but, significant impact on the forex market. The logic behind the changes in the gold policy was explained in my earlier speeches on the subjects of capital flight and gold. The major thrust of the liberalisation process in gold policy centred around opening up of additional channels of import, a logical consequence of which was the reduction in differential between the international and domestic price of gold. The price differential of gold was as high as 67 per cent in 1992 when the structural reform process was initiated; it fell to 6 per cent by the end of 1998. The unofficial market in foreign exchange which drew its sustenance from the illegal trade in gold went out of existence as an immediate fall out. In essence, the import of gold which was largely on unofficial account in earlier years, was officialised, and correspondingly the foreign exchange used to finance such unofficial imports was also officialised, mainly through enhanced flow under invisibles account.

Various deposit schemes have been designed from time to time to suit the requirements of non-resident Indians (NRIs). Currently, we have three NRI deposit schemes, viz., Non Resident External (NRE) account which is denominated in rupees, Non Resident Non Repatriable (NRNR) account, which is non-repatriable rupee account except for the interest component which is repatriable, and the Foreign Currency Non Resident (Bank) (FCNR-B) account which is a foreign currency account. Banks have also been allowed considerable freedom in deployment of these funds. Of interest to forex markets is the operation of FCNR-B scheme, because banks have to bear exchange risk. Banks either hold these deposits in foreign currency investing them abroad or lend in foreign currency to corporates in India or swap into rupees and lend to Indian corporates in rupees. When corporates borrow in foreign currency, there is an inflow into the market but there may be hedging by corporates. When banks swap into rupees and lend, there is an impact on forex markets but forward premia and lending rates in rupees are critical. Thus, tracking the use of FCNR (B) deposits is essential in appreciating forex markets.

Operations of large public sector undertakings have a significant impact especially on spot market, and their procedures for purchase or sale of foreign currency also impact on market sentiments. To this end, and in order to enable Public Sector Enterprises (PSEs) to equip themselves in formulating an approach to management of foreign currency exposure related risks, the Government of India had set up a Committee in January 1998. The Report of the Committee explicitly brings out the approach that is appropriate for risk management with reference to the foreign currency exposure of PSEs. PSEs with large volume of foreign exchange exposure were also advised by the Committee to consider setting up Dealing Room for undertaking treasury functions both for rupee and foreign exchange which include management of rupee resources, foreign exchange transactions and risk management. Adoption of approaches recommended would enable the PSEs to spread their demand and supply in forex market, in a non-disruptive way to the benefit of both the PSE concerned and functioning of forex market in India.

The setting up of Off-shore banking units at this advanced stage of financial liberalisation in our country is considered by many to be unnecessary and that the time for an offshore banking unit has gone. In a country of our size, the issue of linkages between off-shore sector and the domestic sector is undoubtedly an important one. We need to make a clear distinction between the financial issues and the non-financial issues on the subject. From the central bank's perspective, designing appropriate regulatory framework is important and the most important issue is ensuring of a firewall between the off-shore transactions and domestic transactions. Physical location is not relevant, especially when deposit taking and cash transactions are not permitted in off-shore business. In fact, we do not have a good model of real off-shore centre in a country with capital controls. Confederation of Indian Industry (CII) with assistance from the Government of Maharashtra is engaged in a detailed study of the various issues to make recommendations to the RBI and the Government of India.

The idea of establishing a Foreign Exchange Clearing House (FXCH) in India was mooted in 1994. The Expert Group on Foreign Exchange Markets in India also recommended introduction of foreign exchange clearing and making netting legally enforceable. The Scheme was conceived as multilateral netting arrangement of inter-bank forex transactions in US dollar. The membership would be open to all ADs in foreign exchange participating in the inter-bank foreign exchange market. RBI will also be a participating member. The net position of each bank arrived at the end of the trading day would be settled through a Clearing Account to be maintained by RBI. It was recognised that a substantial reduction in number of Nostro account transactions of the participating banks would lead to economy in settlement cost and efficiency in settlement. Other benefits include easing the process of reconciliation of Nostro accounts balances by banks, reduction in size of credit and liquidity exposure of participating banks and hence systemic risk, etc. The long-term objective is to establish clearing house as a separate legal entity with risk and liquidity management features, infrastructure and operational efficiency akin to other leading clearing systems. However, to start with, we may aim at commencing the operation with such minimum modification to the scheme as may be necessary. For the present, the focus areas are legal, risk and liquidity aspects and operational infrastructure, and all these issues are under examination in the RBI.

In a regime where exchange rates were fixed and there were restrictions on outflow of foreign exchange, the RBI encouraged the banks to constitute a self regulatory body and lay down rules for the conduct of forex business. In order to ensure that all the banks participated in the arrangement, the RBI placed a condition while issuing foreign exchange licence that every licensee agree to be bound by the rules laid down by the banker’s body – the FEDAI. FEDAI also accredited brokers through whom the banks put through deals. There is increasing emphasis now on competition, and fixing or advising charges by professional bodies is being viewed with disfavour and often treated as a restrictive trading practice. It is currently argued by some that with the growth in volumes and giant strides in telecommunication, banks may no longer need to deal through brokers when efficient match making arrangements exist. As in some other markets, the deals are concluded on the basis of voice broking and it is sometimes held that this often results in conclusion of deals which are less than transparent, evidenced by instances where deals have been called off on payment of differences. Under the circumstances, there is perhaps a need to review several aspects, viz., compatibility of advising or prescribing fees with pro-competition policy; role of brokers; electronic dealing vis-ŕ-vis voice broking; and relationship between the RBI, FEDAI and authorised dealers.

• First, there are some limits on freedom accorded to banks, such as ones on borrowing and investing overseas; ceilings on interest rates and maturities of non-resident foreign currency deposits; and these could be reviewed at appropriate time, with a view to liberalising them prudently.

• Second, the medium-term objective of reducing cash reserve requirements to the minimum prescribed in the statute and the longer term objective of proposing amendments to the statute to make all the reserve requirements flexible will be pursued, consistent with developments in fiscal and monetary conditions.

• Third, the restoration of freedom to corporates to hedge anticipated exposures is continuously under review. However, the issue of restoration of facility to rebook cancelled contracts needs to be reviewed with caution.

• Fourth, the extension of facility of forward cover to FIIs is also under continuous review, though facilities available now are yet to be fully utilised by FIIs.

• Fifth, trading in derivatives is a desirable objective, but a number of preconditions are to be satisfied in the matter of institutional as well as regulatory arrangements. This is a complex task, but certainly is on the agenda of reform.

• Sixth, setting up a forex clearing house is on the agenda and it is essential to design it on par with other leading clearing systems in the world.

• Seventh, a number of recommendations of Tarapore Committee have been accepted, and others are also reviewed from time to time. A view will have to be taken on each one of them only in the context of overall liberalisation of capital account, which in turn, depends on, among other things, progress of our financial sector reforms and evolving international financial architecture.

• Eighth, development of deep and liquid money market with a well-defined yield curve in place is an accepted objective of RBI. The actions taken and those contemplated to perform this hard task have already been articulated in my earlier speeches on money and debt markets, and the recent Monetary and Credit Policy Statement of April 1999 has provided evidence of RBI's approach in this regard.

• Ninth, implementation of the recommendations of the Report on Public Sector Enterprises will facilitate the efficient management of their foreign currency risks and also even out lumpy demand and supply situations in the forex market.

• Tenth, while there is a dominant view that setting up Mumbai as an off-shore financial centre is no longer a necessity, the views of CII, which is posing the issue, may have to be awaited and considered seriously.

• Eleventh, in any effort to develop markets, role of self regulatory bodies is critical. The role of FEDAI in achieving greater competition, efficiency and transparency in the forex markets needs to be reviewed on a continuous basis, so as to keep pace with developments in technology and financial sector reforms.

• Twelfth, a number of legislative changes are under contemplation, and of these the ones relating to Foreign Exchange Management and Money Laundering are critical to development of forex markets. Harmonisation between existing institutions, regulations and practices, including transition path to new legislative framework would be a significant task in the context of forex market development.

• Thirteenth, several representations have been received by Regulations Review Authority to simplify, streamline and rationalise some of the regulatory and reporting requirements pertinent to foreign exchange. The RRA should be taking a final view in the matter, on the basis of expected report of group of Amicus Curiae, within a few weeks.

• Fourteenth, in the area of technology, on-line connectivity has been initiated in respect of data transmission by market to the RBI. Once this system is fully established, it will lead to a very prompt and effective on-line monitoring by RBI as well as reduction in multiplicity of reporting statements. Similarly, initiatives are underway to expedite back office linkage between banks themselves and with RBI for settlement, which will fructify once the VSAT is fully operational.

To conclude, the medium-term objective of developing an efficient and vibrant forex market continues to be an important priority within the overall framework of development of financial markets. Naturally, the pace and sequencing have to be determined by both the domestic and international developments. In particular, the unique features of Indian forex markets, legal, institutional and technological factors, and developments related to macro-economic policies would govern the path of moving towards the medium-term objective, without sacrificing freedom in tactical measures to respond to unforeseen circumstances in the very short-term.