Regulatory steps and future of currency futures: Economic Times 11th June 2008

Currency futures are once more the flavour of the season. They are needed to enable price discovery for hedging operations as there are a large number of players involved who would be looking at them. More so because the rupee, which was appreciating sometime back creating problems of monetisation for RBI has suddenly started depreciating. The outlook continues to be nebulous as is the case with all markets. The present OTC set-up, though efficient, is opaque. And there is an alternative that exists. However, there is one thought that comes to mind, which has to be addressed in the light of the Abhijit Sen Committee report on futures trading in commodities. The report at some stage provokes further debate on whether futures trading can be effective in a commodity where there is a lot of government intervention. In case of commodities, the allusion was to wheat where the minimum support price causes a distortion. If one looks at the forex market, then traces of familiarity can be seen in the behaviour of the RBI. Today, the exchange rate is determined by market forces, but there is substantial intervention by the RBI as prudential monetary policy also entails keeping an eye on the exchange rate. Therefore, when forex currency swells, the RBI intervenes and ensures that the rupee does not appreciate too fast. This, in turn, could go against the ethos of market-determined exchange rates. Now, if one looks back over the last 60 months (monthly data evens out anomalies), there is a strong correlation between forex currency stocks and exchange rates at 0.84, meaning thereby that high levels of reserves are associated with high levels of exchange rates. But, then exchange rates do not change drastically in any time period anyway. However, changes in these two variables and their resulting correlation are more pertinent as trade will be driven by these conjectures. The correlation virtually disappears (0.01) if the incremental foreign currency is mapped to changes in the rupee-dollar rates. In fact, in this period of 60 months, an inverse relationship is witnessed in only 35 months, which means that in over 40% of the cases, the increase in forex currency has not resulted in an appreciation of the rupee. Left to the market forces, the rupee should have appreciated, which has not happened, mainly due to regulatory intervention. Now, the violation of this principle is not unusual because there is the issue of excessive monetisation, which the RBI tries to ward off by mopping up these assets and preventing the rupee from appreciating. This means that the market principles guiding price movements is susceptible to intervention by the regulatory authority. Hence, as is the case with the commodity market, when there is a MSP or its equivalent of a maximum tolerable change in exchange rate, which is notionally held by RBI, there would tend to be distortions in prices. The players would have to conjecture what the RBI has in mind when bidding on the future rate. But, unlike the MSP, the RBI’s vision is a variable that changes more frequently — 4 times a year when the monetary policy is announced and also an equivalent number of times in between. But, the task becomes onerous as the RBI is known to intervene even on a daily basis in case of large swings in the exchange rate.
Therefore, one solution that could be espoused here is that the RBI will have to be actively involved in the contract design and also specify its level of comfort with currency rate swings which should be taken as the daily price band beyond which the market could also expect intervention from RBI. But, this is not efficient. Besides, the RBI can never tell what would be the tolerable limit and when it would intervene. Therefore, there would always be an issue of regulatory intervention making the market jittery. The efficient functioning of this market will hence be challenged time and again by possible RBI intervention and the accompanying regulatory costs. Besides conjecturing moves of the Fed and ECB, and deficits in these regions, market layers have to continuously read the RBI’s mind — which is not an easy job to do.