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Foreign Exchange Markets: Rajesh Chakrabarti
Foreign Exchange Markets: Rajesh Chakrabarti
Rajesh Chakrabarti*
Introduction
During 2003-04 the average monthly turnover in the Indian foreign exchange
market touched about 175 billion US dollars. Compare this with the monthly trading
volume of about 120 billion US dollars for all cash, derivatives and debt instruments put
together in the country, and the sheer size of the foreign exchange market becomes
evident. Since then, the foreign exchange market activity has more than doubled with the
average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the
daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,
foreign exchange constitutes the largest financial market by far.
Liberalization has radically changed Indias foreign exchange sector. Indeed the
liberalization process itself was sparked by a severe Balance of Payments and foreign
exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system
replete with severe import and foreign exchange controls and a thriving black market is
being replaced with a less regulated, market driven arrangement. While the rupee is
still far from being fully floating (many studies indicate that the effective pegging is no
less marked after the reforms than before), the nature of intervention and range of
independence tolerated have both undergone significant changes. With an overabundance of foreign exchange reserves, imports are no longer viewed with fear and
skepticism. The Reserve Bank of India and its allies now intervene occasionally in the
foreign exchange markets not always to support the rupee but often to avoid an
*
College of Management, Georgia Tech, 800 West Peachtree Street, Atlanta, GA 30332, USA. Email:
rajesh.chakrabarti@mgt.gatech.edu .
appreciation in its value. Full convertibility of the rupee is clearly visible in the horizon.
The effects of these development s are palpable in the explosive growth in the foreign
exchange market in India.
than tripled, growing at a compounded annual rate exceeding 25%. Figure 1 shows the
growth of foreign exchange trading in India between 1999 and 2006. The inter-bank
forex trading volume has continued to account for the dominant share (over 77%) of total
trading over this period, though there is an unmistakable downward trend in that
proportion. (Part of this dominance, though, result s from double-counting since purchase
and sales are added separately, and a single inter-bank transaction leads to a purchase as
well as a sales entry.) This is in keeping with global patterns.
[Figure 1 about here]
In March 2006, about half (48%) of the transactions were spot trades, while swap
transactions (essentially repurchase agreements with a one-way transaction spot or
forward combined with a longer- horizon forward transaction in the reverse direction)
accounted for 34% and forwards and forward cancellations made up 11% and 7%
respectively. About two-thirds of all transactions had the rupee on one side. In 2004,
according to the triennial central bank survey of foreign exchange and derivative markets
conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee
featured in the 20th position among all currencies in terms of being on one side of all
foreign transactions around the globe and its share had tripled since 1998. As a host of
foreign exchange trading activity, India ranked 23rd among all countries covered by the
BIS survey in 2004 accounting for 0.3% of the world turnover. Trading is relatively
moderately concentrated in India with 11 banks accounting for over 75% of the trades
covered by the BIS 2004 survey.
The Indian rupee has had an active forward market for some time now. The
forward premium or discount on the rupee (vis--vis the US dollar, for instance) reflects
the markets beliefs about future changes in its value. The strength of the relationship of
this forward premium with the interest rate differential between India and the US the
Covered Interest Parity (CIP) condition gives us a measure of Indias integration with
global markets. The CIP is a no-arbitrage relationship that ensures that one cannot borrow
in a country, convert to and lend in another currency, insure the returns in the original
currency by selling his anticipated proceeds in the forward market and make profits
without risk through this process.
Chakrabarti (2006) reports tha t between late 1997 and mid-2004 the average
discount on the rupee was about 4% per annum. During the period the average difference
between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was
about 4.5% for 3-months and 3.5% for the 6- months period. With these two figures in the
same ballpark (particularly given that bank deposit rates and inter-bank rates are not
strictly comparable), annual averages of interest rate differences and the forward
exchange premium also indicate a moderate degree of co- movement between the two
variables. The interest rate differential explains about 20% of the total variation in the
forward discount. The deviation of the Indian rupee-US dollar from the covered interest
parity, however, exhibits long-lived swings on both sides of the zero line. This would
indicate arbitrage opportunities and market imperfections provided we could be sure of
the comparability of the interest rates considered. Therefore, while the behavior of the
forward premium on the Indian rupee is broadly in lines with the CIP, more careful
empirical analysis involving directly comparable interest rates is necessary to measure
the strength of the covered interest parity condition and the efficiency of the foreign
exchange market.
Under market efficiency, the forward exchange rate is considered to be an
unbiased predictor of the future spot rate, with random prediction errors. While the
prediction errors of forward rates on the rupee appear to show some degree of
persistence, any conclusion in this matter too must await more rigorous analysis.
among all the 53 countries considered. Clearly the Indian rupee has been an excellent
tracker of the US dollar.
It is instructive to consider the Rupee-Dollar exchange rate in the light of the
purchasing power parity (PPP) holding that the exchange rate between two currencies
should equal the ratio of price levels in two countries. In its dynamic form PPP holds that
that the rate of depreciation of a currency should equal the excess of its inflation rate to
that in the other country. Over a reasonably long period of time, the devaluation in the
Indian Rupee, vis--vis the US dollar does seem to have an association with the
difference in the inflation rates in the two countries. Between 1991 and 2003, the two
variables have had visible co- movements with a correlation of about 0.57 (Chakabarti
(2006)). This may be a result of Indo-US trade flows dominating the exchange rate
markets but it is perhaps more likely that it reflects the exchange rate management
principles of the monetary authorities
The Reserve Bank of India has used a varied mix of techniques in intervening in
the foreign exchange market indirect measures such as press statements (sometimes
called open mouth operations in central bank speak) and, in more extreme situations,
monetary measures to affect the value of the rupee as well as direct purchase and sale in
the foreign exchange market using spot, forward and swap transactions (see Ghosh
(2002)). Till around 2002, the measures were mostly in the nature of crisis management
of saving-the-rupee kind and sometimes the direct deals would be repeated over several
days till the desired outcome was accomplished. Other public sector banks, particularly
the SBI often aided or veiled the intervention process.
The exact details of the interventions are shrouded in mystery, not unusual for
central banks ever wary of disclosing too much of their hand to the currency speculators.
The Tarapore Committee report had urged more transparency in the intervention process
and recommended, in 1997, that a Monitoring Exchange Rate Band of 5% be used
around an announced neutral real effective exchange rate (REER), with weekly
publication of relevant figures, something yet to be implemented. In a recent survey on
foreign exchange market intervention in emerging markets, the Bank for International
Settlements (BIS (2005b)) found that out of 11 emerging market countries considered,
India gave out most complete information on intervention strategy (along with three
others); no information on actual interventions (five others did the same) and did not
cover foreign exchange intervention in annual reports (like two other countries). On the
whole it ranked fourth most opaque in matters of foreign exchange intervention among
the eleven countries compared.
Close on the heels of the adoption of market determined exchange rate (within
limits) in 1993 came current account convertibility in 1994. In 1997, the Tarapore
committee, on Capital Account Convertibility, defined the concept as the freedom to
convert local financial assets into foreign financial assets and vice versa at market
determined rates of exchange and laid down fiscal consolidation, a mandated inflation
target and strengthening of the financial system as its three main preconditions.
Meanwhile capital flows have been gradually liberalized, allowing, on the inflow side,
foreign direct and portfolio investments, and tapping foreign capital markets by Indian
companies as well as considerably better remittance privileges for individuals; and on the
outflow side, international expansion of domestic companies. In 2000, the infamous
Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign
Exchange Management Act (FEMA) that gave participants in the foreign exchange
market a much greater leeway.
The ultimate goal of capital account convertibility now seems to be within the
governments sights and efforts are on to chalk out the roadmap for the last leg, though it
is not expected to be accomplished before 2009. Expectedly, the wisdom of the move has
been hotly debated . Advocates of convertibility cite the consumption smoothing
benefits of global funds flow and point out that it actually improves macroeconomic
discipline because of external monitoring by the global financial markets. Convertibility
can spur domestic investment and growth because of easier and cheaper financing. It can
also contribute to greater efficiency in the banking and financial systems. On the other
hand, skeptics like Williamson (2006), for instance, points out that India is yet to fulfill at
least one of the three major preconditions to Capital Account Convertibility set out by the
Tarapore committee, viz. fiscal discipline, with a public sector deficit of 7.6% of the GDP
and the ratio of public debt to GDP of over 83% in 2005-06. In any case, the argument
goes, the benefits of convertibility do not necessarily outweigh the risks and cross-border
short-term bank loans usually the last item to be liberalized are the most volatile. It is
generally held that it was, in fact, the lack of convertibility that protected India from
contamination during the Asian contagion in 1997-98.
10
earning low returns on the safe assets used to park the reserves. Given this low rate of
return, there has been discussion about the unique proposal to use part of the reserves to
fund infrastructure projects.
Outlook
Liberalization has transformed Indias external sector and a direct beneficiary of
this has been the foreign exchange market in India. From a foreign exchange-starved,
control-ridden economy, India has moved on to a position of $150 billion plus in
international reserves with a confident rupee and drastically reduced foreign exchange
control. As foreign trade and cross-border capital flows continue to grow, and the country
moves towards capital account convertibility, the foreign exchange market is poised to
play an even greater role in the economy, but is unlikely to be completely free of RBI
interventions any time soon.
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References
Bank for International Settlements, 2005a. Triennial Central Bank Survey: Foreign
exchange and derivatives market activity in 2004, Basel, Switzerland.
Bank for International Settlements, 2005b. Foreign exchange market intervention in
emerging markets: motives, techniques and implications, BIS Paper No.24, Basel,
Switzerland.
Chakrabarti, Rajesh, 2006. The Financial Sector In India: Emerging Issues, Oxford
University Press, New Delhi, 2006.
Ghosh, Soumya Kanti, 2002. RBI Intervention in the Forex Market: Results from a Tobit
and Logit Model Using Daily Data, Economic and Political Weekly, June 15,
pp.2333-2348.
Williamson, John, 2006, Why Capital account Convertibility in India is Premature,
Economic and Political Weekly, May 13, pp.1848-1850.
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May-99
13
Time
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Fig. 1:
Forex Trading activity
600
Inter-bank trade volume*
500
Merchant trade volume
400
300
200
100