India: India’s Foreign Exchange Market

Until 1993, India maintained an administrative exchange rate. From its independence from the British to 1971, India had a fixed exchange rate against the currency of its former rulers. This was however done in consultation with the International Monetary Fund. After the collapse of the fixed exchange rate system in 1971, the currency was linked to the British pound, but not for long. As other economies gained prominence in India’s economic relations, there was a need to maintain stability vis-à-vis with other currencies too. 1975 onwards, the Indian rupee was linked to a basket of currencies and was devalued from time to time in order to maintain stability. Following India’s economic liberalisation in 1991, the currency was devalued by 18% and administered exchange rate lived side by side the market too. Also, the Indian currency began being quoted against the U.S. dollar – a change from its pound based quote. It was only in 1993, that the rupee was made to float. The Indian currency was now tradable in the market.

India's forex market is a multi-tiered market where the commercial banks that quote the domestic unit against the US dollar, are at the centre of activity. The rupee is not quoted against any other currency in this rate discovering market. Businesses that need to transact in foreign currency, do so with an authorised dealer (generally a commercial bank) as they are not permitted to deal directly with each other.

In general, the rupee's exchange rate is characterised by stability against the dollar followed by a sharp depreciation ranging from 2% to 7%. However, if one takes into account inflation and the movement of other major currencies like the yen, mark and the pound, the domestic currency has been nearly stable in the past seven years. The central bank comes in from time to time in the market to buy or to sell dollars in order to stabilise the market, which it does successfully. The central bank is also sometimes nearly absent from the market, even during a movement.

Last year, the Indian rupee slid 7% against the dollar to INR 46.90 per USD. The high international prices of oil were chiefly blamed for the rupee's decline. India's oil imports had soared by over 60% during the April -December period of 2000. Also, portfolio investments did not seem to grow in a stagnant stock market that had already lost a third of value from its peak during the year. Only after the largest commercial bank, the State Bank of India (SBI) borrowed over five billion dollars from overseas Indians, did the confidence in the domestic currency crawl back. From another point of view, even after the 7% fall of the domestic currency, it stood at the same level as it was at the time it was made to float in early nineties. Central bank's own published data on the inflation adjusted & trade weighted rate for the rupee with respect to 93-94, stood neutral/unchanged after the fall. In other words, the rupee was overvalued before the fall began in May 2000. A third of India's exports go to Europe. This makes it difficult to ignore the movements in the euro's exchange rate. By April 2000, the rupee had appreciated by 19% against the euro since August 1999. And at that point of time the inflation rate stood at 6½%. For the purpose of analysing the rupee, the focus has traditionally been on the current account. The capital account flows and its impact on the exchange rate started gaining significance only in the 1990s. The size of capital account transactions is smaller at $ 70 billion and is half the size of current account transactions. Nevertheless, portfolio investment is a volatile figure that can affect the exchange rate in the short run. During June & July in 2000, foreign portfolio investors sold $ 526 million worth of assets in the Indian market. And in the first three months of 2001, they bought assets worth $ 1.7 billion. However, in the financial year 1999 - 2000 (April 1999 to march 2000), portfolio flows were only an eighth of the current account flows. Moreover, with the rupee being fully convertible only on the current account, the focus tends to be more on the trade. On one hand, a strong rupee hurts the exports, on the other a significantly weak rupee can fuel inflation.

Risk & Derivatives:

On the derivatives side, there is a forward market for rupee: dollar. Interestingly, this market is not based on the interest parity principle as in other markets. If more dollars are sold forward, the premium on the dollar tends to be lower, and vice-versa. The local forward market is greatly influenced by the current account transactions, with the exception of forward dollars bought for debt servicing. The importers and exporters are chief participants in the forward market. This market is liquid upto a maturity of one-year. Beyond that, the transactions are more on individual basis between the banks and their clients. Because the market is quoted only in dollars, other currencies are quoted on the basis of prevailing international rates. For example, the spot rupees per euro exchange rate is derived by multiplying the international $ per euro rate by the domestic rupee per dollar rate. The same mechanism also extends for the forward rates, where demand supply generated rate in one market is crossed with the interest rate differential generated rate in the other. Futures and options are absent from India's foreign exchange market, due to regulatory restrictions. However, commercial banks can sell options to Indian businesses in cross currencies by buying the same from international markets. Indian businesses are not allowed to write options under any circumstances. The central bank has adopted a very cautious approach to opening up of the derivatives market and does not wish to expose the banks and businesses to risks that they may not yet be ready to deal with. The same philosophy is also adopted in the spot market (the underlying market) where the volatility is curtailed.  But, businesses with payables in foreign currency might find themselves on the receiving end when the currency begins to slide by a sizeable magnitude after months-long stability. On the other hand, businesses with foreign currency receivables face risk in terms of the rupee's appreciation (like last year’s rise over euro). Many businesses are beginning to manage these risks. However, the currency risk is better-understood vis-à-vis the USD than other currencies, primarily on account of the market being a rupee: dollar one. INR: USD swaps are also a part of the market. Swaps can be undertaken between a bank & its client, though regulation forces banks to keep their positions arising out of such deals, square.

In the last decade, the size of India's foreign exchange markets has not kept pace with the growth in foreign exchange flows. This has not helped liquidity and aggravates risks by way of volatility.  India has moved slowly but steadily towards its goal of a more open economy. This trend is likely to continue in the foreseeable future. India’s experiment with capital account convertibility would be a case study of huge significance to most emerging economies who would like to benefit from its positive aspects, considering that after the Asian crisis in 1997-98 the reversal of international capital flows has become a scary word for many developing economies. Now, Indian companies can also invest abroad (though not without some restrictions). As India integrates with and develops markets overseas, risks vis-à-vis many other currencies becomes apparent. That leaves a lot of scope for development in derivatives market – in rupee: dollar and also dollar: international currencies in India.