Project on Indian Financial Market Structure
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Foreign Exchange Market Structure

The foreign exchange market in India comprises customers, authorised dealers (ADs) and the Reserve Bank. With the transition to a market determined exchange rate system in March 1993 and the subsequent gradual but significant liberalisation of restrictions on various external transactions, the forex market in India has acquired more depth.

The growing depth of the Indian forex market in the 'nineties reflects essentially the result of the implementation of a number of recommendations of three important committees, viz., the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan), the Report of the Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani) and the Committee on Capital Account Convertibility (Chairman: Shri S.S. Tarapore).

Since the unification of the exchange rate in March 1993, several measures have been introduced to widen and deepen the forex market.

1. First, banks have been given the freedom to

   1. fix net overnight position limits and gap limits (with the Reserve Bank formally approving the limits),

   2. initiate trading position in the overseas markets,

   3. determine the interest rates of NRI deposits (Linked to LIBOR in the case of FCNR(B) deposits) and maturity period [minimum maturity of one year in the case of FCNR(B) deposits].

2. Secondly, inter-bank borrowings have been exempted from statutory pre-emptions.

3. Thirdly, banks have been permitted the use of derivative products for asset-liability management.

4. Fourthly, in order to facilitate integration of domestic and overseas money markets, ADs have been allowed to borrow abroad.

However, as a prudential measure, their external borrowings have been related to their capital base. At present, ADs are allowed to avail of loans, overdrafts and other types of fund based credit facilities from their overseas branches and correspondents up to 15 per cent of their unimpaired Tier I capital or US $ 10 million or its equivalent, whichever is higher. The funds are allowed to be used for any purpose - other than lending in foreign currencies. ADs have been provided the flexibility to cross these limits solely for replenishing their rupee resources in India for normal business operations and not for deployment in the call money or other markets. In such instances, a report on each borrowing has to be immediately forwarded to the Reserve Bank and its prior permission is needed for repayment of such loans. Such permission would be given only if the AD has no borrowings outstanding from the Reserve Bank or other bank/financial institution in India and the concerned AD is clear of all money market borrowings for a period of at least four weeks before the repayment. Fifthly, corporates have been provided significant freedom in managing their foreign exchange exposures. They are permitted to hedge anticipated exposures, though this facility has also been temporarily suspended after the Asian crisis. Exchange Earners' Foreign Currency (EEFC) account entitlement has also been rationalised. Risk management strategies like freedom to cancel and rebook forward contracts have been allowed to corporates, although currently due to Asian crisis, freedom to rebook cancelled contracts is suspended. However, corporates are allowed to roll over the contracts. Other risk management tools like cross-currency options on back-to-back basis, lower cost option strategies like range forwards and ratio range forwards and hedging of external commercial borrowing (ECB) exposures have been allowed subject to prudential requirements.

The customer segment of the spot market in India essentially reflects the transactions reported in the balance of payments. Although as percentage of GDP, gross inflows and outflows have not increased significantly, in absolute value terms, there has been a two-fold increase in the merchant transactions in the 'nineties'. Current transactions, however, continue to dominate the capital transactions. The merchant segment of the market continues to be dominated by select public sector units, in particular, the Indian Oil Corporation (IOC), and the Government of India. In the post-1993 period, the foreign institutional investors (FIIs) have also emerged as major players in the foreign exchange market with some evidence of links between the FII flows and the behaviour of the exchange rate. During the four major phases of net FII outflows, the exchange rate of the rupee seemed to depreciate. While earlier the debt service requirements of the Government and IOC were being routed through the Reserve Bank, since 1996 such demands have also been routed through the market. As the forex demand on account of public sector units and the Government tends to be lumpy and uneven, resultant demand-supply mismatches entail occasional pressures in the forex market, warranting market interventions by the Reserve Bank.

There has been a considerable improvement in the forex market turnover in the recent years, particularly during the post-reform period. The total turnover, i.e., merchant and inter-bank taken together, in the forex market increased by 6-fold between the period 1987-88 to 1999-00. The average monthly turnover increased from about US $ 17 billion in 1987-88 to US $ 50 billion in 1993-94 and further to US $ 109 billion in 1998-99. Reflecting restrictions on re-booking of cancelled forward contracts for imports and splitting of forward and spot legs of a commitment, the monthly turnover declined to US $ 95 billion in 1999-00. The inter-bank turnover constitutes the predominant part of total turnover. The proportion of inter-bank turnover in total turnover increased from 82 per cent in 1987-88 to 91 per cent by 1991-92 but declined to less than four-fifths by 1999-00. As regards the classification by way of spot and forward transactions, available data for the recent period indicate that the merchant segment is dominated by spot transactions, while the inter-bank segment is dominated by forward transactions. During 1999-00, spot transactions accounted for about 55 per cent of total merchant turnover, while the forward transactions formed 40 per cent of total inter-bank turnover.

In the Indian forex market, which is essentially transactions driven, interbank transactions in the spot segment mostly facilitate market making. At times, however, inter-bank transactions also reflect the "day trading" pattern. With restrictions on overnight overbought and oversold positions, day trading allows one to benefit from the intra-day exchange rate movements without violating the close of the day position limits. During normal market conditions, the ratio between inter-bank and merchant transactions should be somewhat stable. In the face of disorderly conditions, tendency for day trading may increase and, as a result, the ratio may increase. Whenever the Indian rupee was under pressure, the ratio of inter-bank spot transactions to merchant transactions tended to exceed the average, suggesting that day trading activities increase during volatile market conditions.

In the forward/swap segment of the market, importers and corporates generally tend to rush for cover when the spot market turns disorderly and prefer to keep their positions open during stable market conditions. This creates occasional large mismatches in the forward segment of the market. If merchant sale in the forward segment is used as a proxy for forward demand by importers and merchant purchase in the forward segment is used as a proxy for supplies by exporters in the forward market, then the ratios of monthly forward demand to monthly imports and monthly forward supply to monthly exports could explain the sensitivity of exporters and importers to forward market in India. The ratio of demand for forward cover to imports remained below one during stable market conditions, but got close to one or exceeded one whenever the spot exchange rate came under pressure. Two-way movement in the exchange rate is essential to increase the sensitivity of exporters and corporates to the forward market.

Initiation of longer maturity contracts up to one year represents a healthy development in the forex market. According to the BIS Survey on Global Foreign Exchange markets, the maturity breakdown of outright forward transactions in different markets shows that while for the global market as a whole the share of one year contracts was about 4 per cent, in India it was close to 3 per cent. Forward contracts up to seven days, however, represented 51 per cent of total outright forward transactions in the world as against 22 per cent in India. This could be on account of the restrictions in the Indian market that without an underlying transaction, an agent cannot enter into a forward contract.

The Reserve Bank's presence in the market essentially reflects its policy of ensuring orderly market conditions. Reflecting its stance, net intervention sales of the Reserve Bank generally coincided with conditions of excess demand in the market, while net intervention purchases coincided with surplus market conditions and contributed to reserve build-up.