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?