The RBI task force to study offshore rupee markets under the chair of Usha Thorat, a former deputy governor, submitted its report last week.
The objective of the committee, which was set up by the central bank in its sixth bi-monthly monetary policy for 2018-19, was to analyse factors behind the development of the offshore rupee market, its impact and suggest measures if this trading leads to any concerns.
First, some basics. India like most other countries maintains accounts for transactions with the rest of the world called balance of payments (BoP). BoP is divided into current and capital accounts. The current account deals in exports and imports of goods and services (and remittances). The capital account is a mirror of the current account, meaning if exports are greater than imports, then there will be capital outflows to balance the account (and capital inflows when imports are greater).
Most countries, including India, have liberalised the current account, implying that one can buy (sell) freely from (to) other countries. The trouble is liberalising the capital account where quite a few countries, especially non-developed ones, have restrictions on inflows and outflows. This is because capital flows are seen as fickle and move very quickly between countries — just a click of mouse is all it takes.
For instance, say, a country relies on capital inflows to balance its current account deficit (like India) and gets these flows normally. But if there is a crisis situation in India or abroad, these flows can exit quickly, making it difficult to manage the import bill. Thus, policymakers place restrictions on capital flows and conversion of foreign exchange into domestic currency. These restrictions led to the development of the offshore rupee market.
Foreigners cannot trade in rupees abroad and instead settle transactions in the notional currency. Say, a foreign investor expects the rupee to depreciate compared to the dollar in 3 months and buys a forward for the Indian currency. If the rupee was fully convertible, it means the investor will be able to settle transactions in the currency. However, due to restrictions on convertibility, the person will settle transactions in the dollar and not the rupee, which is named as non-deliverable forward (NDF).
NDF markets started in currencies like the Korean won, Brazil real and the like and developed in global financial centres such as London and Singapore where one is free to trade in all kinds of products. Thus, they are also called offshore markets.
There are multiple reasons why the NDF market is a problem. First, the exchange rate in the two markets, home and offshore, could be different leading to arbitrage opportunities and inefficiencies. In fact, the price in one market could drive the price in another market. The Thorat Committee report pointed out that how during the two crises (2013 and 2018), it was the price in the NDF market that led to changes in the home market.
Second, governments impose restrictions on capital flows to avoid excessive volatility. However, the emergence of the NDF market and the arbitrage situation could lead to similar conditions of volatility. Third, the NDF market implies that transactions are happening elsewhere leading to revenue losses for domestic financial firms.
As the Indian economy has become more globalised, the rupee has become an important NDF market as well. Even before the Thorat panel, the Tarapore committee (2006) and the Mumbai International Financial Centre Report (2007) had advocated removing restrictions on capital flows to prevent developing of NDF market. However, back then, volumes in rupee NDF were low.
The daily turnover in NDF market was $23 billion in 2008 which comprised 11.5 percent of all forwards and 1.3 percent of overall forex activity. The daily turnover has jumped to $139 billion, which stands at 34 percent of all forwards and 5.3 percent of the forex market.
Within global trends, the daily turnover of rupee NDF was around $100 million in 2006 (according to the Tarapore committee), but is now at $23 billion. Between onshore and offshore markets, we see share of offshore remains volatile, but it is significant and in 2017-18 was larger than onshore markets.
The committee gives multiple suggestions to incentivise non-residents to participate in the onshore market and address concerns for the offshore market, if any.
First, one major reason for existence of the NDF market is market hours. The Indian onshore market closes before the opening of markets elsewhere. The committee has suggested that onshore market hours should be extended.
Second, Indian banks should be free to offer competitive pricing of forex products and open access to the FX trading platform to non-residents.
Third, currently, foreign investors can only enter plain vanilla forwards and options which prevent effective hedging. This needs to be corrected.
Four, the committee has suggested that India’s International Financial Centres such as GIFT City (see my previous piece on GIFT city) can also offer NDFs, but it should first start with currency derivatives in the rupee.
Five, KYC procedures, documentation and taxation policy have to be streamlined and in line with international standards.
There is a feeling that these suggestions can only go so far in bridging the gaps between onshore and offshore markets. The key issue is whether we should remove restrictions on the capital account so that offshore markets disappear.
The committee does reflect on whether India should remove restrictions on capital account, but decides against it. The sentiment has changed significantly since the 2008 crisis in favour of restrictions on capital account. Even the likes of IMF which always argued for liberalising capital account are now suggesting having capital controls as part of policy toolkit.
The committee is trying to provide a middle ground by continuing with capital controls and still figuring out ways to bring investors from offshore market to the onshore market. Middle grounds do help balance objectives, but keep one indecisive as well.
Amol Agrawal is faculty at Ahmedabad University. Views expressed are personal.Subscribe to Moneycontrol Pro and gain access to curated markets data, trading recommendations, equity analysis, investment ideas, insights from market gurus and much more. Get Moneycontrol PRO for 1 year at price of 3 months at 289. Use code FREEDOM.