Musings on FEDAI, Forex Market
and Indian Rupee* Harun R. Khan
Dr. T. V. Nagendra Prasad, Charge d’ Affairs,
Embassy of India, Mr. Phillipe Welti, former Ambassador
of Switzerland to India & Bhutan, Mr. Beat Siegenthaler,
Executive Director, UBS, Ms. Varsha Vasant Purandare,
Chairperson, Foreign Exchange Dealers Association of
India (FEDAI), Mr. D. G. Patwardhan, Chief Executive
Officer, FEDAI, Mr. N. S. Venkatesh, Chairman, The
Fixed Income Money Market and Derivatives Association
of India (FIMMDA), Mr. C.E.S Azariah, Chief Executive
Officer, FIMMDA, Mr. G. Mahalingam, Chief General
Manager, Reserve Bank of India, and distinguished
delegates to the 7th Annual Conference 2012 of FEDAI.
2. It is a pleasure to be with you in this beautiful city of Zurich and discuss some of
the contemporary issues which are likely to pave way for the new order that is
being ushered in for creating a more robust, more transparent and less risky
financial sector. As you would be aware, a host of committees under the aegis
of the Bank for International Settlements (BIS), which is headquartered close to
Zurich in Basle, are rewriting rules governing the banking and market practices
and India is a part of most of these committees. The regulatory regime of the
international financial architecture is undergoing a metamorphosis post recent
global financial crisis. In this scenario, it is perhaps appropriate that a forum like
this reviews the relevance of the existing order, with particular reference to our
foreign exchange market, in the light of fast changing developments around us.
3. I shall start my address by revisiting the role of the FEDAI. I shall focus more
generally what should be the role of a Self-Regulatory Organization (SRO) in
today's context and particularly what should be the role of FEDAI in the
changed environment of our forex market. Moving over to some of the core
issues relating to the forex market in India, I will briefly touch upon some of the
recent measures taken by the Reserve Bank. Finally, I will briefly discuss the
issue of internationalization of Indian Rupee, a subject which is assuming
critical importance in the context of search for alternative reserve currencies
and the role for currencies of major Emerging Market Economies (EMEs) like
China and India.
Evolution of FEDAI in the changing environment of Indian forex market
4. As you may be aware, in the early post-Independence years, under the Foreign
Exchange Regulation Act (FERA), 1947, a few foreign banks, designated as
Exchange Banks were permitted to transact foreign exchange business. The
terms and conditions for undertaking such business were being laid down by
the then Exchange Banks’ Association. With the increase in India’s foreign
trade, several scheduled commercial banks were authorized by the Reserve
Bank to deal in foreign exchange business. This led to the formation of FEDAI
on August 16, 1958 with a mandate to lay down the terms and conditions which were mandatory in nature for the Authorized Dealers (ADs). With developments
in the Indian foreign exchange market and growth in external trade, the role and
responsibility of FEDAI underwent changes. I am happy to note that FEDAI,
through its members, continues to play a pivotal role in dissemination of the
foreign exchange related banking expertise across the country which has led to
significant improvement in the customer service.
5. Let me now highlight two important milestones
in the evolution of Indian forex market. In the year
1994, an Expert Group on Foreign Exchange Market in
India was set up under the Chairmanship of Shri. O. P. Sodhani, the then Executive Director, Reserve Bank of
India (popularly known as the Sodhani Committee).
The Committee had made wide-ranging
recommendations, ranging from methodology for
correct computation of Open Exchange Position to
introduction of Rupee-based options and these
suggestions had laid the foundation for a modern
foreign exchange market in India. FEDAI played an
important role in supporting the Reserve Bank in
implementing these pioneering measures and
suggestions aimed at major reforms in the market. The
second milestone was the replacement of restrictive
FERA with the Foreign Exchange Management Act
(FEMA) in the year 2000. This provided further fillip to
the development of the foreign exchange market which
can be gauged from the rise in the average daily forex
market turnover from approximately US$ 6 billion in
2001 to nearly US$ 60 billion in 2010-11. This figure
excludes the daily turnover in the exchange-traded
currency futures market which would add up to another
US$ 5 to 7 billion a day. The depth of the foreign
exchange market can also be gauged from the fact that
the bid-offer spread in USD-INR pair is now around half
a paisa. The average daily foreign exchange turnover
has, however, showed a dip since the second half of
December 2011. One plausible reason for the decline
could be the administrative measures taken by the
Reserve Bank of India to moderate the excessive volatile
conditions prevalent in the foreign exchange market
but I will touch upon this issue a bit later in my address.
Future role and responsibilities of FEDAI
6. Having briefly touched upon the significant role
played by the FEDAI so far, let me now turn to the
possible future role and responsibilities of the FEDAI
with special focus on should FEDAI become a fullfl
edged self regulatory organisation (SRO).
7. Many countries rely on self-regulation because
expensive resources are required to regulate the
financial markets effectively, especially in large and
complex markets. With the existence of an effective
SRO, often referred to as frontline regulator, the
statutory regulator (the Regulator) relies on the SRO to
carry out supervision of operations and activities of the
market participants. The supporters of the idea of selfregulation
claim that it offers significant advantage over direct government/statutory regulation. This can be
attributed to the fact that SROs have thorough domain
knowledge of their respective area and regulatory
framework within which they operate. Therefore, they
are considerably more flexible, context-driven and are
able to respond faster to the changes in market
conditions. This also allows the Regulator to spare its
resources more on identifying and responding to major
systemic risks and to other priorities outside the ambit
of self-regulation. It is believed that self-regulation
system works effectively because of the business
incentive to operate in a fair, financially sound and
competitive marketplace. The critics, on the other hand,
argue that private profit-seeking enterprises cannot be
trusted to regulate their own activities as such selfregulation
tends to create an illusion of regulation. In
addition to the conflict of interest, critics of selfregulation
point to certain other inefficiencies, such as,
widespread collective action problems, lack of effective
enforcement capabilities, inability to gain or maintain
legitimacy and the failure of accountability.
8. Having weighed the views of the supporters and critics of the SRO system and
in view of the increasing complexities of financial markets and activities, it is
important to realize and emphasize that industry self-regulation cannot fully
replace government regulation and supervision of the financial services sector.
At the same time, it may not be out of place to say that co-operation amongst
the statutory regulators and SROs in an increasingly complex financial
environment is no longer an option but a necessity. Co-ordination and
communication should be structured to address potential problems before they
occur. One of the important regulatory lessons learnt from the recent global
financial crisis is the need for a concerted response. The Government or the
Regulator alone cannot provide an effective response. Active engagement of
market participants, in particular through industry organizations, such as, SROs
and other industry bodies with some self-regulatory capacity, is essential to
craft practical regulatory responses and to act effectively on policy changes.
9. In this era of fast paced liberalizations and developments, FEDAI should
gradually assume the role of a full-fledged SRO. Typically, a generic and
effective SRO in its template of elements cover, inter alia, internal rulemaking
process, authorisation and access to market-place, including
fitness/qualification standards for market intermediaries, surveillance of market
activities, administration of dispute resolution, sharing information and cooperating
with other SROs and the regulators, etc. SROs enable members to
exercise self-discipline, make regulations more responsive to market demand
and also promote innovation and development in a market based approach.
This is critical for the development of the financial markets in order to make
them competitive, regionally and globally, and improve standards of conduct by
self-regulation.
Developmental role of FEDAI
10. When the Reserve Bank issues instructions, it is expected that the instructions
are understood, interpreted and implemented in a uniform and customer friendly
manner by all ADs without building up system level stresses. In the absence of
unambiguous clarity of instructions to the base level official, the objectives of
various measures initiated by the Reserve Bank may not yield the desired
results. With the advent of FEMA which aims at facilitating external trade and
payments besides promoting orderly development and maintenance of forex
market in India, the economy has been witnessing rapid liberalizations. In such
a scenario, FEDAI needs to monitor the level of customer service and
consumer protection provided by its members and try to fill the gaps arising out
of inadequate knowledge or operational bottlenecks. The Reserve Bank has been emphasizing the need for designing some basic training module covering
the rules & regulations and also the operational guidelines for the frontline staff
at the branch and corporate office levels. Such a module will help them in
improving the foreign exchange related customer service, reduce incidents of
complaints and bring down the level of correspondence seeking clarifications
both within the bank and from the Reserve Bank. Member banks of FEDAI and
the Reserve Bank have since formed a Group which is working to develop an elearning
module to address these concerns. Another related area where FEDAI
is expected to play an important role is in framing of a Citizens’ Charter in the
area of foreign exchange business.
Role of market participants – freedom with responsibility
11. Let me now turn to the second part of my address, perhaps more relevant to
many in the audience in our current context.
12. An efficient market not only requires proper infrastructure, knowledge, skills and
enabling environment but also a great degree of market discipline reflected
through responsible behaviour by all the market participants. As was
experienced during the recent global financial crisis, among other reasons, the
greed of insensitive financial engineers for short term gains caused huge
financial and economic damages to some of the most developed nations and
markets. This has, in fact, become a major focus of discussions across the
jurisdictions after the financial crisis.
13. In the past, it has been argued that market discipline can play a key role in
incentivizing market participants to limit their excessive risk taking activities.
The events of the last few years, however, have proved the inadequacy of
market discipline. Bankers have been found to be actively engaged in risktaking
activities disguised as value-creation. Time and again market participants
have engaged in herd behaviour and put the financial system at risk, at times by
encouraging speculative build-up in the name of hedging for risk management.
The events of the past few years tell us that market discipline expressed via
market prices cannot be expected to play a major role in constraining risk
taking. Therefore, the primary constraint needs to come from regulation and
supervision. Since the ADs are the major players in the domestic foreign
exchange market in India, one would expect much higher responsibility from
them. Reserve Bank has come across instances where a few banks failed to
live up to that kind of expectations and have deviated from the ethics by misselling
forex derivative products which resulted in enormous problems for the
banks as also for the corporates some of which were carried away by the greed
of making money from activities other than their core business operations.
14. As you may recall, the existing guidelines on Over
the Counter (OTC) foreign exchange derivatives were
revised in December 2010 in the context of developments
in the international and as well as the domestic
markets. The revised guidelines put more emphasis on
the suitability and appropriateness aspects of products
being offered. Market-makers have been advised to
undertake derivative transactions with a sense of
responsibility and cautioned to avoid, among other
things, mis-selling. These products are to be offered to
corporates who understand the nature of the risks
inherent and have a well-laid down risk management
policy. Such policy must clearly lay down, inter alia,
guidelines on risk identification, management and
control, prudent accounting and disclosure norms and
must be capable of ascertaining the mark-to-market
positions on an on-going basis. In fact, the Reserve Bank
has made it mandatory for the market participants to
offer a tool or a calculator which would enable the
corporate to mark-to-market these products on a
continuous basis. Though the objective of the policy is
prudential in nature as it protects the market participant
against the credit, reputation and legal risks, it is
important to realise that the policy protects the interest
of the corporates as well.
15. Let me also reiterate that banks need to closely monitor the un-hedged foreign
currency exposures of corporates as they had hedged approximately only 60
per cent and 38 per cent of their trade and non-trade related exposures
respectively till December 2011. Excessive risk taking by corporates could lead
to severe distress to them and large credit loss to the banks in event of sharp
adverse movements in currencies. In 2008, it was conveyed to the banks that
they should have a Board approved policy covering un-hedged foreign
exchange exposure of all the clients including Small and Medium Enterprises.
Banks while extending fund and non-fund based credit facilities to corporate,
should rigorously evaluate the risks arising out of un-hedged foreign currency
exposure of the corporates and price them in the credit risk premium as we
have recently reiterated in our circular following the announcements made in
the Second Quarter Review of the Monetary Policy 2011-12.
16. During the recent episode of excessive volatility leading to sudden and sharp
depreciation of Indian Rupee against US Dollar, it was noticed that the flexibility
given to banks for fixing their intra-day limits, which were in many cases,
significantly higher than their net overnight open positions limits, were often
being used for building up speculative positions and taking a directional bet on
Rupee. The facilities given to corporates by way of cancellation and re-booking
of their forward contracts and booking of forward contracts under past
performance criterion were also not being used in the right spirit. As you would
appreciate such speculative forces tend to be self-reinforcing and often result in
a situation where exporters keep on deferring their receipts and importers rush
in to buy forwards, thus aggravating the situation in hand. The administrative
measures undertaken by Reserve Bank in the month of December 2011 were
aimed at curbing these speculative behaviour of such entities. The measures
did achieve the intended policy objectives and also led to an immediate fall in
the volumes of the markets. The actual hedging requirements of the real sector,
however, were not left unattended as we subsequently relaxed some of the
measures to accommodate customer needs. Within the overarching prerequisite
of facilitating genuine hedging needs of the customers, Reserve Bank
would consider relaxations, in particular those relating to intra-day position
limits, in a calibrated manner at appropriate time.
17. Let me assure you that Reserve Bank will continue with its calibrated and
gradual approach towards liberalisation of the foreign exchange market in India
but at the same time we will expect greater degree of responsibility and
accountability from all the participants. In the context of our measured approach to market liberalisation, there has been a lot of debate on scope of wider usage
of Indian Rupee both in the region/abroad, or in other words, internationalization
of Indian Rupee. I will now briefly touch upon the issue in the third and last part
of my address.
Challenges for Internationalization of Indian Rupee
18. In view of the recent crisis in the financial market
which resulted in a slowdown in the world economy, some views have emerged from various quarters on
whether the Indian Rupee could play a larger role as an
international currency. This issue assumed a topical
and, if I may add, patriotic significance when the symbol
for Indian Rupee was unveiled amidst huge media
publicity. Proposals for use of local currencies of the
EMEs under bilateral and multi-lateral arrangements
including the initiatives taken by China for Yuan and
the recent suggestions emanating from BRICS nations
have provided renewed focus to this. It is a known fact
that wide acceptance by participants in trade and
financial markets makes a currency a popular option
for trade settlement and for maintenance of reserves.
The characteristics which a currency needs to possess
before it could become popular as a transactions
currency would include free convertibility, ability to
invest, borrow, issue marketable instruments, significant
volumes of international trade in different regions,
stability of the exchange rate, the currency being a
favoured choice for invoicing which would, inter alia
depend on the mutual negotiating strength of trading
partners, availability of deep foreign exchange markets,
cost-effective hedging facilities including forward cover,
availability of efficient banking arrangement/market
infrastructure, etc.
19. Based on the analysis of Prof. Peter Kenen of Princeton University, we can lay
down the following seven broad prerequisites for the process of
internationalization of a currency.
-
Domestic entities are permitted to invoice some of their exports in the
country’s currency, and similarly foreign entities are also allowed to invoice
their exports in that country’s currency;
-
There should be no restrictions on any entity, domestic or foreign, to buy/sell
its country’s currency in the spot and forward markets. In other words, there
should be freedom of foreign-exchange trading by domestic and foreign
entities and no limits be imposed on holding the domestic currency and
derivative instruments denominated in it;
-
Foreign entities/financial institutions/official institutions, and individuals, are
permitted to hold the country’s currency and financial instruments
denominated in it as a part of prudent investment strategy/the official
reserves;
-
Foreign entities, including official institutions, are able to issue marketable
instruments in the country’s currency. These may include both equity and
debt instruments, not only in the country’s domestic markets but also in
foreign markets, including, the home country markets of the foreign entities;
-
The issuing country’s own financial institutions and other entities are able to
issue in foreign markets instruments denominated in that country’s currency;
-
International and regional financial institutions are able to issue debt
instruments in a country’s market and use its currency in their financial
operations;
-
The currency may be included in the “currency baskets” of other countries, in
consideration of their own exchange-rate policies.
20. Measured against the above pre-requisites
for internationalisation of currency, Indian Rupee
is certainly far away from any meaningful
internationalisation. Of course, a few measures taken
in the recent years deserve some attention. Since the
introduction of FEMA, the Indian Rupee invoicing is a
permitted form of invoicing under the current trade
and FEMA regulations. In order to facilitate greater use
of Indian Rupee in trade transactions, the Reserve Bank
of India has now allowed non-resident importers and
exporters to hedge their currency risk in respect of
exports from and imports to India, invoiced in Indian
Rupees. In this regard, forward foreign exchange
contracts with Indian Rupee as one of the currencies
and foreign currency-Indian Rupee options are the
available products for the purpose of hedging the risks.
Non-resident exporter/importer can avail of the facility
either directly from ADs in India or through their
banker overseas. The AD, on the basis of the documentary
evidence and undertakings provided by the nonresident,
has to be satisfied of the bona-fides of the
customer as well as of the transaction. As with all other hedging facilities available to non-residents, these
contracts once cancelled cannot be re-booked. We would
be happy to have your feedback on this particular
measure announced by the Reserve Bank of India as it
is almost nine months since the same was announced.
21. Eligible borrowers have been permitted to avail of
External Commercial Borrowings (ECBs) designated in
Indian Rupee from their foreign equity holders under
the automatic/approval route. In order to hedge the
currency-risk arising out of such ECBs, forward foreign
exchange contracts with Indian Rupee as one of the
currencies, foreign currency-Indian Rupee options and
foreign currency-Indian Rupee swaps have been
permitted.
22. The debate on internationalisation of a currency
often goes hand-in-hand with that on capital account
convertibility. It is a known fact that capital controls
can co-exist with an international currency. Economic
history is rich with examples of countries, especially
advanced countries with an international currency,
imposing a variety of capital controls to stem the
depreciation/appreciation of their currencies
and/or to regulate short-term capital flows. While
internationalisation of a currency is not a pre-requisite
for capital account convertibility, its large-scale
externalisation has the potential to impose significant
costs, especially over the medium to long-term as the
real and financial sectors of a country grow and develop
strong linkages with the world economy.
23. The pace and the process of internationalisation
of a currency is, of course, dependent on the acceptable
degree of capital account convertibility. This, in turn,
involves the extent to which non-residents are allowed
to participate in the domestic forward foreign exchange
markets to obtain cover and invest in the domestic
markets for any Indian Rupee balances that they may
accumulate. At the same time, the benefits and costs
of the Indian Rupee becoming an international currency
needs to be reckoned. The benefits broadly include
reduction of exchange-risk for domestic exporters/
importers as risks would instead have to be taken by
the overseas party and extensive use of Indian Rupee
by non-residents would mean increased seigniorage.
Domestic entities can also access international financial markets without exchange rate-risk and can avail of
larger amounts of investment at a lesser cost than in
the domestic market. Expanded investor base and
reduction in the cost of capital may help both the
financial sector intermediation and the real sector.
Governments, particularly those with high fiscal deficit,
may benefit by foreign participation in its debt market
and get the benefit of higher flows to finance the current
account deficits. The costs would include difficulty in
managing the implications for monetary policy and
exchange rate management besides the administrative
costs. Under the ‘Impossible Trinity’ framework, higher
internationalisation would severely limit either the
country’s flexibility to influence the monetary
condition, such as, interest rate, money supply. or
manage exchange rate under stress situations. Coming
to the issue of benefit to domestic entities/government
by way of easy access to external resources, the huge
risk in terms of increased vulnerabilities arising out of
sudden stops, panic outflows unrelated to fundamentals
of the economy, speculative bets by large pools of
international funds, loss of confidence in the context
of size of reserves in relation to external debt,
particularly short-term debt, have to be reckoned with.
These vulnerabilities have now been accentuated in
the context of the recent global financial crisis.
24. It is also imperative to understand that unlike
countries with current account surpluses, India
generally has a sizeable quantum of current account
deficit. The exchange rate of Indian Rupee remains
susceptible to ebb and flow of external capital,
especially outflows during periods of stress. Given the
growing level of our twin deficits of fiscal and current
account, hasty internationalisation could only add to
our external sector vulnerabilities. As has been
witnessed in the past, sudden reversal of capital flow
imparts significant volatility to the exchange rate which
at times needs to be curbed by the Reserve Bank. In the
event of internationalisation of the Indian Rupee, the
exchange rate would be largely determined by the
sentiments of the market forces and the present policy
measures to curb such volatilities may not prove to be
as effective as they are today. These are some initial
thoughts on the subject which you would be discussing in detail tomorrow. We would look forward to views/
suggestions that would emerge from the deliberations
of the panel here and thereafter, particularly if we can
identify some low risk but macro-economically
beneficial areas, such as, progressive use of Indian
Rupee in trade account given the need to further boost
our exports sector.
Concluding Thoughts
25. Economy and financial markets of India are in the
midst of rapid transformation due to its increasing
linkages with the rest of the world. In keeping with the
changing needs, Reserve Bank of India has been striving
for more simplification, liberalisation and rationalisation
of the policies and the processes in the area of foreign
exchange administration without jeopardising the
financial stability. Market-players, therefore, now have
more freedom to undertake transactions as compared
to the earlier days. These flexibilities, however, should
be utilised in a responsible manner that is transparent,
fair and beneficial to the customers and the economy as a whole and not mis-utilised for short-term gains of
a few market-players with adverse consequential effects
on our financial sector. Therefore, the role of FEDAI
assumes greater significance in the present context.
There is, thus, a need to have a closer look at the
working and functions of FEDAI and strategise on how
to transform it to a full-fledged and responsive SRO.
This would be a win-win proposition for all the
stakeholders including the banks, customers and the
regulators like the Reserve Bank of India. I am sure that
the deliberations in this conference will generate
practical ideas on the future role of FEDAI, especially
as we continue to make progress in our calibrated
approach towards capital account convertibility coupled
with the measures being taken to deepen and broaden
our forex market and facilitate greater use of Indian
Rupee, particularly in the trade account.
26. I wish you all the very best for productive business
sessions followed by the pleasure of exploring the
sublime and scenic beauty of Switzerland.
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