Market Maniac

Internationalization of the Rupee
Feb 20, 2017

Over the past twenty years or so, there have been many committees set up to assess the prospects and processes for capital account convertibility, and, more recently, internationalization of the rupee. This second is more encompassing, including as it does enabling Indian companies to sell to (and buy from) international customers (sellers) and/or to borrow from global investors in Indian rupees.


To judge from the current state of the FX market, we are still quite a way from this goal.


It would seem obvious that as we approach internationalization of the rupee, the early impact would be increasing volume and depth in the FX market. The renminbi, which is now being used in significant volumes in international trade, saw its volumes soar by over 500% between 2010 and 2016; it is now the 8th most actively traded currency.


In the case of the rupee, FX volumes are rising stodgily, despite our high GDP growth rate. In 2016, INR was the 18th most actively traded currency, with $ 56 bn traded a day, comprising 1.1% of global turnover (as compared to $ 198 bn/day comprising 4% of global turnover for CNY). Between 2010 and 2016, volumes did grow but by only 56%, better than overall FX market growth (28%) but a far cry from the kind of pace we would need to internationalize the currency. However, the bulk of the growth – from $ 34 bn a day to $ 50 bn a day – was from 2010 to 2013, with the last three years seeing a weak 11% growth in volumes.


Further, INR derivatives markets are relatively poorly developed – 72% of volumes are spot and outright forwards; the balance is distributed between swaps (22%) and options (6%). For CNY, the equivalent numbers are 48% for spot and outright forward, 44%for swaps and 9% for options. Again, and importantly, 40% of INR turnover is off-shore, similar to the 38% off-shore volumes for CNY.


So, while international entities are, indeed, using the rupee more and more, domestic users of the FX market, have to contend with very thin market conditions. The main reason for this squeeze on domestic volumes has been RBI policy, driven by Dr. Rajan (since he became governor in 2013) and apparently continuing under the present Governor. Rajan said that he believed that low currency volatility would lead to lower inflation expectations – I’m not sure I agree with that. As we see from the last Monetary Policy announcement, RBI is getting more concerned about rising inflation expectations (because of a host of uncontrollable factors, like US fiscal policy and oil prices) even though currency volatility remains numbingly low.


This squeeze on market volumes is only one negative aspect of the central bank’s efforts at damping volatility. The other, and potentially equally pernicious, effect is to lull companies with FX borrowings into a sense of security – reports suggest that well over 70% of FX borrowings remain unhedged. As a result of this, the domestic derivatives market remains underdeveloped – off-shore rupee derivatives are much more liquid out to long tenors, with off-shore prices more attractive for hedging.


This good liquidity in the off-shore derivatives market partly explains the increasing success of masala bonds. It is inconceivable that professional investors – other than developmental investors like IFC – would invest in medium- to long-rupee assets without hedging the risk.


In sum, a pre-requisite for internationalization of the currency, as, indeed, for providing domestic companies with better risk management facilities, is to actively work to increase volumes in the on-shore market for both spot and derivatives.


Dropping the focus on containing volatility is a necessary first step.


Permitting different entities to access the FX market is another. In global markets, non-bank financial institutions (primary dealers, AD2s, investment banks, mutual funds, pension funds, insurance companies, alternative investment vehicles, etc.) provide nearly 50% of market volumes; in the case of the rupee, non-bank FIs provide just 20% of market volumes and virtually all of it is off-shore.


However, even as we need to address these issues, it seems to me that the rupee is far from an ideal candidate for internationalization. First off, while it is true that India is one of the fastest-growing economies in the world, the truth is that our trade is a miniscule part of world trade and, more importantly, we are a price taker rather than a price maker in virtually every sphere. Thus, our companies have very little leverage as compared to, say, Chinese companies who are now routinely selling mobile phones and energy infrastructure in renminbi.


Secondly, our banking system is a mess – not just in terms of the current state of balance sheets but, more critically, in terms of ownership. It appears extremely unlikely that this government will ever bite the bullet on that one. Without effective management of institutions that control the vast bulk of banking assets, it makes no sense to even think about internationalization. We also need to focus on building our strengths structurally – our “ample” reserves, for instance, are not really assets in that they comprise mostly investment flows which have been bought by the central bank rather than, as in the case of China, actual net FX earnings.


Thus, in my view, internationalization of the rupee is still a ways off; however, we need to move rapidly towards making the on-shore hedging markets more deep and liquid.





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