When a credit market gets overheated, governments and regulators must step in
Bear Sterns, Fannie Mae and Freddie Mac (and Northern Rock somewhere along the way), Lehman Brothers, Merrill Lynch and AIG are all big-sounding financial names which a year back inspired awe in the layman.
Today they are symbolic of what has gone wrong in an area where it seemed nothing could go wrong and whose impact stretches across the world. It involves not just the highly paid managers and other back-office employees, but also central banks and governments where everyone is involved and has to create new ideologies or break old ones to keep the system alive.
Lehman Brothers and Merrill Lynch have run large losses to the extent that one has filed for bankruptcy while the other has managed to find a buyer. This is a result of the fallout of the sub-prime crisis which claimed Bear Sterns and Northern Rock last year and hit the twins earlier this year. The story leading to this crisis was straightforward. While interest rates were lowered by the US Federal Reserve over the years, people borrowed like mad. Home loans were provided without due diligence and came to be called NINJA loans (no income no jobs no assets).
There was a property boom which sent prices upwards and cheap loans provided the enticements. These loans were bundled and securitised — a process where these loans are converted into securities (asset-backed securities) and resold in the market. This is where these investment banks stepped in.
These CDOs (collateralised debt obligations) fetched higher rates and the investment banks borrowed funds to invest in them. Once the rates started moving up, problems began. Home owners started defaulting. Simultaneously higher interest rates drove down the property prices and as indebted home owners left their keys back and disappeared, the collateral value had fallen. This meant that the housing finance companies took a hit as did those who dealt with the securities in the CDO market backed by these houses.
The crisis has now entered a dangerous phase. If Lehman's assets are avoided in the process of liquidation, there will be a chain reaction and similar assets on other firms' books will have to be marked down. One take-away from this Lehman episode is that the industry is harsh and is not willing to rescue the sick, even when the consequences of inaction are potentially dire.
The other concern is the impact on the credit-default swap market where Lehman holds contracts with a notional value of almost $800 billion.
The story obviously is more intricate but the gist was that such over-leveraged purchases of assets provided a double whammy on both sides leading to a collapse. Usually when there is a collapse of such a magnitude, a bail-out is expected. Northern Rock had it when Bank of England intervened and Freddie Mac, Fannie Mae and Bear Stearns had the US government intervening.
Governments either directly provide relief or get the monetary authorities to lower rates. This has in a way set a precedent of moral hazard as the so-called wrong-doers are bailed out.
The debate now is whether or not such bail-outs are desirable? Going by economist Joseph Schumpeter's theory, financial failures are necessary to separate the good from the bad and they start the process of creative destruction. If we destroy our own institution, then it may not matter. However, if your own destruction rocks the entire global system, then someone will help out. Therefore, if one has to destroy, make the destruction big! This line of thought is not sustainable.
Hank Paulson could be lauded for letting Lehman file for bankruptcy but the issue of AIG is ticklish, which has an exposure of around $ 450 billion. Goldman Sachs and JP Morgan were approached for a fresh fund infusion of $ 120 billion, but there was no interest.
The Fed has finally announced an $ 85 billion loan for its revival, which thus blows hot and cold over the approach to financial moral hazard. Spurning Lehman, it has in a fortnight bailed out huge mortgage companies and an insurer. The puzzle is, why not Lehman?
What are the lessons to be learnt? The first is that no institution is too big to fail. The second is that failures should not ideally be bailed out as they set precedents of moral hazard. Third, the securitisation market is still an unknown quantity.
Fourth, when assets are fraught with risk, over-leveraging in a booming market is not a prudent policy. Lastly, regulators and governments need to be more observant when there is a boom, rather than reactive when the crisis descends. This way the intensity of the crisis can be moderated and the pain lowered.
Thursday, September 18, 2008
Tuesday, September 16, 2008
Tackling the banking camel: Financial Express: 16th September 2008
Dr Subbarao takes over as governor of RBI at an interesting stage, when he has to cast the dice in favour of either growth or inflation. Also, banking is on the threshold of some new challenges that have to be taken head-on. The now familiar acronym of CAMEL in banking parlance takes on the following form: capital, asset quality, monetary policy, emerging banking scenario and lending.
Subbarao was once the secretary of the PM's Economic Advisory Council, a group that put our growth at 7.7% for the year. He now heads an institution that has been more optimistic at 8% in its target. On the face of things, this should not matter because a 0.3% growth in GDP is just around Rs 10,000 crore. But, psychologically the number of 7.7% looks satisfactory while 8% seems impressive.
The other reason why this difference matters is that the overall monetary stance will depend on whether we pitch for 7.7 or 8%. If we are speaking of 8%, the governor has to think hard before increasing the pressure on the brakes and may have to consider a loosening of the strings. But, if 7.7% is acceptable, then he will be satisfied with the current state of affairs.
The fact that he was in the PM’s advisory council also means an ostensible shift from a government official who looks at the politics of Economics to an Economist at the Central Bank who should ideally give greater weight to Economics. With an election in the vicinity, this will mean a focus on tackling inflation. The fact that the prices of commodities are softening and that past monetary measures should start delivering from October means that there is comfort to be had.
All governors have gotten typecast for certain actions. Dr Reddy had favoured a CRR intervention while Dr Jalan had the knack of coming in when no one expected RBI action. It will take some time before the media and the market start typecasting this governor.
The banking sector will need to be prepared as per Basel II. One of the biggest challenges is capital for further expansion. Fund requirements will be especially enormous because our 8% growth model is dominated by infrastructure, industrial and construction sectors. Presently, the banking system is compliant on this score, with a large number of banks having capital adequacy ratios of over 10%. In 2009 we will see the banking sector open up to greater foreign participation, which will mean more competition. Skeptics are saying we should not hurry on this front. Privatisation of public sector banks also needs to be tackled with a new perspective. How do public sector banks start disinvesting their equity? Should they be sold to the public or other banks, and do the latter include foreign and private banks? Will private sector banks survive in this competitive set up?
Against the background of the sub-prime crisis, the RBI also has to take a deeper look at asset quality. A US-like situation is not really visible in the Indian context, but home loans have been growing even as interest rates on them have risen from 8% to 12-14%. The RBI will need to be alert.
The elections will also demand a balancing act between loan waivers and inclusive lending. Inclusive lending tends to be associated with higher NPAs, which have also been part of the waiver story. While the burden of waivers is being borne by the government, there is a new moral hazard, which incentivises defaults. The banks would have to take the stick and this also has to be addressed by the RBI.
So, Subbarao has very interesting challenges ahead of him, and the fact that he has been part of the government will amplify his political compulsions. On the other hand, being one of the better economists, he will be aware of these pitfalls and their solutions. This story should unfold in the next year or so.
Subbarao was once the secretary of the PM's Economic Advisory Council, a group that put our growth at 7.7% for the year. He now heads an institution that has been more optimistic at 8% in its target. On the face of things, this should not matter because a 0.3% growth in GDP is just around Rs 10,000 crore. But, psychologically the number of 7.7% looks satisfactory while 8% seems impressive.
The other reason why this difference matters is that the overall monetary stance will depend on whether we pitch for 7.7 or 8%. If we are speaking of 8%, the governor has to think hard before increasing the pressure on the brakes and may have to consider a loosening of the strings. But, if 7.7% is acceptable, then he will be satisfied with the current state of affairs.
The fact that he was in the PM’s advisory council also means an ostensible shift from a government official who looks at the politics of Economics to an Economist at the Central Bank who should ideally give greater weight to Economics. With an election in the vicinity, this will mean a focus on tackling inflation. The fact that the prices of commodities are softening and that past monetary measures should start delivering from October means that there is comfort to be had.
All governors have gotten typecast for certain actions. Dr Reddy had favoured a CRR intervention while Dr Jalan had the knack of coming in when no one expected RBI action. It will take some time before the media and the market start typecasting this governor.
The banking sector will need to be prepared as per Basel II. One of the biggest challenges is capital for further expansion. Fund requirements will be especially enormous because our 8% growth model is dominated by infrastructure, industrial and construction sectors. Presently, the banking system is compliant on this score, with a large number of banks having capital adequacy ratios of over 10%. In 2009 we will see the banking sector open up to greater foreign participation, which will mean more competition. Skeptics are saying we should not hurry on this front. Privatisation of public sector banks also needs to be tackled with a new perspective. How do public sector banks start disinvesting their equity? Should they be sold to the public or other banks, and do the latter include foreign and private banks? Will private sector banks survive in this competitive set up?
Against the background of the sub-prime crisis, the RBI also has to take a deeper look at asset quality. A US-like situation is not really visible in the Indian context, but home loans have been growing even as interest rates on them have risen from 8% to 12-14%. The RBI will need to be alert.
The elections will also demand a balancing act between loan waivers and inclusive lending. Inclusive lending tends to be associated with higher NPAs, which have also been part of the waiver story. While the burden of waivers is being borne by the government, there is a new moral hazard, which incentivises defaults. The banks would have to take the stick and this also has to be addressed by the RBI.
So, Subbarao has very interesting challenges ahead of him, and the fact that he has been part of the government will amplify his political compulsions. On the other hand, being one of the better economists, he will be aware of these pitfalls and their solutions. This story should unfold in the next year or so.
Monday, September 8, 2008
A Time to Choose: DNA: 8th September 2008
The new RBI governor has to decide between aiding growth and controlling inflation
With a new governor taking over the Reserve Bank of India (RBI), it is a good time to evaluate the prospects for the Indian economy. Four factors must be kept in mind. The first is that there are signs of industry slowing down and inflation is still high.
The second is that we are not alone in this conundrum, as slower growth and inflation are an all-pervasive phenomena and central banks everywhere in the world are trying to resolve these twin problems. The third is that there are some indications of world prices, especially of oil, cooling down.
Lastly, the change of guard at the RBI is germane to this issue because future policy will be guided by a new wave of thinking on Mint Street.
At this moment, the prospects for growth look bleaker than they were last year. The question in one’s mind is whether we will be over 8 per cent this year or fall somewhere below. The majority consensus is that 8 per cent will be difficult. The RBI had also scaled down the number from 8-8.5 per cent in April to 8 per cent in July.
The PM’s Economic Advisory Council (the new RBI governor was a part of this council) had brought it down to 7.7 per cent while others are pitching for 7.5 per cent with a bit of luck. The numbers matter not just for the psychological reasons, as 8 per cent sounds good while anything lower gives the impression that we have lost out somewhere.
The important thing is that even 0.1 per cent difference means that real income of around Rs3,100 crore is lost (our GDP in real terms is Rs31,00,000 cr), and hence the difference between the RBI and the PMO’s projections could mean close to Rs10,000 crore in income.
Broadly speaking, the economic performance will be driven by the kharif harvest and RBI action. The agri outcome will determine the amount of money that will be spent by the people. People in rural India are dependent on the harvest and a good one means that they can spend easily on other industrial goods. Therefore, the months of October-November are critical.
City folk, too, plan their expenses, especially on white goods and automobiles, at this time. In fact, housing projects invariably take off during Dussehra and keys are handed over for new flats at the time of Diwali. It is not surprising that this is the time when companies as well as retailers offer the highest discounts.
These discounts rise during times of an economic slowdown and hence this year we could expect more of such competitive sales for refrigerators, TV sets, washing machines, and the like. The season ends when the New Year comes, which is spending time again for all people as those who missed the bus earlier catch up with their purchases.
This is where the RBI can make a difference, as interest rates will guide spending patterns. The new RBI governor will have to toss the coin for either favouring growth or paying attention to inflation. Higher interest rates could put a spoke in the wheel as consumption decisions are postponed for a while, especially in the mortgage sphere.
At the same time, inflation today is more or else accepted as a double digit phenomenon. No one really expects inflation to come down to 5 per cent this year. In fact, curiously, the comparable numbers for the CPI (consumer price index) inflation are in the region of 7.5-8.5 per cent and hence project a more tolerable picture today. But to expect that inflation will come down to a single digit would be a bit too optimistic.
With all of us getting reconciled to a double digit inflation rate, it may be prudent for the RBI governor to persevere with the growth objective and aim for above 8 per cent growth rate which will mean a more liberal approach to interest rates. The new governor was part of the 7.7 per cent estimate and is now a part of the 8 per cent estimate for GDP.
Even while trying to reconcile the two numbers, he would have to take a judicious call on interest rates. Inflation, as mentioned earlier, is unlikely to come down drastically, and the global conditions probably signal that the worst may be over as of now.
If the RBI is happy with a 7.7 per cent number, then it could continue tightening the monetary side, but if it pitches for higher growth, then rates may have to be reduced to spur demand from both consumption and investment. For this, they also run the risk of spurring inflation, though frankly, once the rate is over 10 per cent, 12 or 13 may not really matter. But with a general election looming in the background, inflation management may be more important. After all, the common man does not understand growth or GDP for that matter. But he knows what inflation is, and that matters the most.
With a new governor taking over the Reserve Bank of India (RBI), it is a good time to evaluate the prospects for the Indian economy. Four factors must be kept in mind. The first is that there are signs of industry slowing down and inflation is still high.
The second is that we are not alone in this conundrum, as slower growth and inflation are an all-pervasive phenomena and central banks everywhere in the world are trying to resolve these twin problems. The third is that there are some indications of world prices, especially of oil, cooling down.
Lastly, the change of guard at the RBI is germane to this issue because future policy will be guided by a new wave of thinking on Mint Street.
At this moment, the prospects for growth look bleaker than they were last year. The question in one’s mind is whether we will be over 8 per cent this year or fall somewhere below. The majority consensus is that 8 per cent will be difficult. The RBI had also scaled down the number from 8-8.5 per cent in April to 8 per cent in July.
The PM’s Economic Advisory Council (the new RBI governor was a part of this council) had brought it down to 7.7 per cent while others are pitching for 7.5 per cent with a bit of luck. The numbers matter not just for the psychological reasons, as 8 per cent sounds good while anything lower gives the impression that we have lost out somewhere.
The important thing is that even 0.1 per cent difference means that real income of around Rs3,100 crore is lost (our GDP in real terms is Rs31,00,000 cr), and hence the difference between the RBI and the PMO’s projections could mean close to Rs10,000 crore in income.
Broadly speaking, the economic performance will be driven by the kharif harvest and RBI action. The agri outcome will determine the amount of money that will be spent by the people. People in rural India are dependent on the harvest and a good one means that they can spend easily on other industrial goods. Therefore, the months of October-November are critical.
City folk, too, plan their expenses, especially on white goods and automobiles, at this time. In fact, housing projects invariably take off during Dussehra and keys are handed over for new flats at the time of Diwali. It is not surprising that this is the time when companies as well as retailers offer the highest discounts.
These discounts rise during times of an economic slowdown and hence this year we could expect more of such competitive sales for refrigerators, TV sets, washing machines, and the like. The season ends when the New Year comes, which is spending time again for all people as those who missed the bus earlier catch up with their purchases.
This is where the RBI can make a difference, as interest rates will guide spending patterns. The new RBI governor will have to toss the coin for either favouring growth or paying attention to inflation. Higher interest rates could put a spoke in the wheel as consumption decisions are postponed for a while, especially in the mortgage sphere.
At the same time, inflation today is more or else accepted as a double digit phenomenon. No one really expects inflation to come down to 5 per cent this year. In fact, curiously, the comparable numbers for the CPI (consumer price index) inflation are in the region of 7.5-8.5 per cent and hence project a more tolerable picture today. But to expect that inflation will come down to a single digit would be a bit too optimistic.
With all of us getting reconciled to a double digit inflation rate, it may be prudent for the RBI governor to persevere with the growth objective and aim for above 8 per cent growth rate which will mean a more liberal approach to interest rates. The new governor was part of the 7.7 per cent estimate and is now a part of the 8 per cent estimate for GDP.
Even while trying to reconcile the two numbers, he would have to take a judicious call on interest rates. Inflation, as mentioned earlier, is unlikely to come down drastically, and the global conditions probably signal that the worst may be over as of now.
If the RBI is happy with a 7.7 per cent number, then it could continue tightening the monetary side, but if it pitches for higher growth, then rates may have to be reduced to spur demand from both consumption and investment. For this, they also run the risk of spurring inflation, though frankly, once the rate is over 10 per cent, 12 or 13 may not really matter. But with a general election looming in the background, inflation management may be more important. After all, the common man does not understand growth or GDP for that matter. But he knows what inflation is, and that matters the most.
Saturday, September 6, 2008
Currency Futures: Questions for the RBI: 6th September 2008: Business Line
The RBI, as the holder of the country’s foreign exchange reserves, has an interest in participating in the currency market, both as the monetary regulator and as a player hedging its own currency risk. Thus, its every announcement will have a significant impact on the market, says MADAN SABNAVIS.
The introduction of currency futures is probably the first of the last set of steps towards in the country’s tryst with capital account convertibility. The exchange rate, which was considered sacrosanct by the RBI in the days of forex shortages and was earlier fixed against a basket of currencies, is now on the threshold of being fully market-determined.
As the forward market is very active today, there is a lot of discussion on how this segment and the futures markets will be integrated. This is more on the commercial side. However, at the ideological level, the question posed is how the RBI’s role will be redefined in this area.
Let us look at the theoretical view on currency futures. Participants would trade in rupee-dollar rates and, hence, determine the futures price. The participants would be both those with exposure to foreign exchange risk, such as exporters or importers, and those who are pure speculators. The rate is decided by the market, and transactions are settled in rupees and not dollars. To this extent there is no pressure on dollar reserves.
The market values the dollar rate based on two benchmarks: the current spot rate and the current forward rate. However, there is no reason to assume that the futures rate will be higher than the spot and equivalent to the forward rates. The future rate is theoretically defined as the spot price plus cost of carry. If the cost of carry is positive, then the futures will be higher than the spot price. However, today, the spot rate is not quite market-determined as the RBI has a role to play here. The RBI ensures that the spot rate does not depreciate or appreciate too drastically, and uses forex reserves to do so. To do this, the RBI buys or sells dollars in the market.
Now the futures market can upset calculations. If, for example, the market believes there will be large capital inflows, meaning that FDI and FII flows will keep increasing by, say, $20 billion in the next three months; the futures rate should logically start appreciating. The forward rate may not capture it as it based more on the spot plus cost of carry concept. At the same time the spot would also get affected by the futures price. If players in the spot market know that the rupee will appreciate, then buyers would defer their purchase while sellers would sell immediately, thus lowering (appreciating) the spot rate. Spot-Futures Correlation
Now, it is not really clear in the derivative markets whether the spot market drives the futures market, or the other way round. But when futures indicate an appreciation, it would tend to feed into the spot market too.
Further, it has been observed that there is no strong correlation between foreign exchange reserves and currency movements. Hence, the spot rates may not really reflect the fundamentals at all times.
Nothing wrong, really, with this line of thought, except that, when it comes to the exchange rate, we have so far not let it move entirely based on market fundamentals. This is so as it affects all other foreign exchange transactions, especially the exporters. In fact, the RBI has played a critical role in ensuring that the interests of the exporters and importers are taken care of along the way.
For example, last year, when foreign investments flooded the country, the rupee was to appreciate rapidly. However, the RBI intervened and held on to the rupee, thus causing an implicit depreciation. Had the futures market existed at that time, the market would have sent similar signals well in advance and the RBI intervention would have given rise to the conundrum of two directions being provided to this rate.Market-determined
The question is whether or not the RBI is prepared for such an eventuality. Going by the experiences of the commodity futures market, where the price of a commodity such as wheat is fixed by the government, an interesting issue is raised.
When the futures market delivered a higher price in 2006, based on the fundamentals, there was an ideological issue raised when farmers preferred to sell to the market rather than the government.
The exchange rate admittedly is not a fixed price, like the MSP, but there has been little firmness in allowing the rate to be fully market-determined.
Therefore, when the price of any commodity is controlled by any entity, a free futures market could run into contradictions at the ideological level.
On the other side, the settlement price would be based on the RBI reference price, in which case the RBI would still control the movements in the futures market.
This rate is, in effect, largely determined by the RBI, in which case the futures market will still be guided by the RBI and there are theoretical limits to which the price could fluctuate.
Again, borrowing from the experiences of the commodity market, where there is no unique spot price, which is therefore polled by the exchanges, the settlement takes place at this price. The spot price is a polled one and is, hence, relatively free from bias, while the reference rate could, as stated earlier, be influenced by the RBI indirectly when it buys or sells foreign exchange in the market.Monetary management
Another puzzle could be in terms of monetary management. Just suppose the futures market becomes the unique force that decides the exchange rate.
Now, let us assume the rupee is appreciating at a rapid rate. From a spot rate of Rs 43.5, the futures indicate a rate of Rs 41.5. Assume that Rs 41.5 is not acceptable for the RBI and it goes in for buying up dollars, thus increasing money supply.
This process will be accelerated when the rupee keeps on appreciating and the RBI may perforce be compelled to follow a tight monetary policy as the market will always have the futures rate in its periscope. Therefore, monetary management will become that much tighter.
A final thought on this market is whether or not the RBI could be a player in the market. The RBI is the holder of the reserves for the country and, hence, owns the largest quantity of foreign exchange. Should it hedge on this platform?
It has, hence, an interest in participation, both in terms of being the regulator of the monetary sector as well as a player hedging its own currency reserves risk.
Even if the RBI does not take direct part in the market, every announcement made would have a significant impact on the market. Can we escape this one?
The introduction of currency futures is probably the first of the last set of steps towards in the country’s tryst with capital account convertibility. The exchange rate, which was considered sacrosanct by the RBI in the days of forex shortages and was earlier fixed against a basket of currencies, is now on the threshold of being fully market-determined.
As the forward market is very active today, there is a lot of discussion on how this segment and the futures markets will be integrated. This is more on the commercial side. However, at the ideological level, the question posed is how the RBI’s role will be redefined in this area.
Let us look at the theoretical view on currency futures. Participants would trade in rupee-dollar rates and, hence, determine the futures price. The participants would be both those with exposure to foreign exchange risk, such as exporters or importers, and those who are pure speculators. The rate is decided by the market, and transactions are settled in rupees and not dollars. To this extent there is no pressure on dollar reserves.
The market values the dollar rate based on two benchmarks: the current spot rate and the current forward rate. However, there is no reason to assume that the futures rate will be higher than the spot and equivalent to the forward rates. The future rate is theoretically defined as the spot price plus cost of carry. If the cost of carry is positive, then the futures will be higher than the spot price. However, today, the spot rate is not quite market-determined as the RBI has a role to play here. The RBI ensures that the spot rate does not depreciate or appreciate too drastically, and uses forex reserves to do so. To do this, the RBI buys or sells dollars in the market.
Now the futures market can upset calculations. If, for example, the market believes there will be large capital inflows, meaning that FDI and FII flows will keep increasing by, say, $20 billion in the next three months; the futures rate should logically start appreciating. The forward rate may not capture it as it based more on the spot plus cost of carry concept. At the same time the spot would also get affected by the futures price. If players in the spot market know that the rupee will appreciate, then buyers would defer their purchase while sellers would sell immediately, thus lowering (appreciating) the spot rate. Spot-Futures Correlation
Now, it is not really clear in the derivative markets whether the spot market drives the futures market, or the other way round. But when futures indicate an appreciation, it would tend to feed into the spot market too.
Further, it has been observed that there is no strong correlation between foreign exchange reserves and currency movements. Hence, the spot rates may not really reflect the fundamentals at all times.
Nothing wrong, really, with this line of thought, except that, when it comes to the exchange rate, we have so far not let it move entirely based on market fundamentals. This is so as it affects all other foreign exchange transactions, especially the exporters. In fact, the RBI has played a critical role in ensuring that the interests of the exporters and importers are taken care of along the way.
For example, last year, when foreign investments flooded the country, the rupee was to appreciate rapidly. However, the RBI intervened and held on to the rupee, thus causing an implicit depreciation. Had the futures market existed at that time, the market would have sent similar signals well in advance and the RBI intervention would have given rise to the conundrum of two directions being provided to this rate.Market-determined
The question is whether or not the RBI is prepared for such an eventuality. Going by the experiences of the commodity futures market, where the price of a commodity such as wheat is fixed by the government, an interesting issue is raised.
When the futures market delivered a higher price in 2006, based on the fundamentals, there was an ideological issue raised when farmers preferred to sell to the market rather than the government.
The exchange rate admittedly is not a fixed price, like the MSP, but there has been little firmness in allowing the rate to be fully market-determined.
Therefore, when the price of any commodity is controlled by any entity, a free futures market could run into contradictions at the ideological level.
On the other side, the settlement price would be based on the RBI reference price, in which case the RBI would still control the movements in the futures market.
This rate is, in effect, largely determined by the RBI, in which case the futures market will still be guided by the RBI and there are theoretical limits to which the price could fluctuate.
Again, borrowing from the experiences of the commodity market, where there is no unique spot price, which is therefore polled by the exchanges, the settlement takes place at this price. The spot price is a polled one and is, hence, relatively free from bias, while the reference rate could, as stated earlier, be influenced by the RBI indirectly when it buys or sells foreign exchange in the market.Monetary management
Another puzzle could be in terms of monetary management. Just suppose the futures market becomes the unique force that decides the exchange rate.
Now, let us assume the rupee is appreciating at a rapid rate. From a spot rate of Rs 43.5, the futures indicate a rate of Rs 41.5. Assume that Rs 41.5 is not acceptable for the RBI and it goes in for buying up dollars, thus increasing money supply.
This process will be accelerated when the rupee keeps on appreciating and the RBI may perforce be compelled to follow a tight monetary policy as the market will always have the futures rate in its periscope. Therefore, monetary management will become that much tighter.
A final thought on this market is whether or not the RBI could be a player in the market. The RBI is the holder of the reserves for the country and, hence, owns the largest quantity of foreign exchange. Should it hedge on this platform?
It has, hence, an interest in participation, both in terms of being the regulator of the monetary sector as well as a player hedging its own currency reserves risk.
Even if the RBI does not take direct part in the market, every announcement made would have a significant impact on the market. Can we escape this one?
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