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  1. 1. VI FOREIGN EXCHANGE MARKET6.1 Globally, operations in the foreign exchange the measures initiated by the Reserve Bank andmarket started in a major way after the breakdown of identify areas for further liberalisation or relaxationthe Bretton Woods system in 1971, which also marked of restrictions in a medium-term framework.the beginning of floating exchange rate regimes in 6.4 The momentous developments over the pastseveral countries. Over the years, the foreign few years are reflected in the enhanced risk-bearingexchange market has emerged as the largest market capacity of banks along with rising foreign exchangein the world. The decade of the 1990s witnessed a trading volumes and finer margins. The foreignperceptible policy shift in many emerging markets exchange market has acquired depth (Reddy, 2005).towards reorientation of their financial markets in The conditions in the foreign exchange market haveterms of new products and instruments, development also generally remained orderly (Reddy, 2006c).of institutional and mar ket infrastr ucture and While it is not possible for any country to remainrealignment of regulatory structure consistent with the completely unaffected by developments inliberalised operational framework. The changing international markets, India was able to keep thecontours were mirrored in a rapid expansion of foreign spillover effect of the Asian crisis to a minimumexchange market in terms of participants, transaction through constant monitoring and timely action,volumes, decline in transaction costs and more including recourse to strong monetary measures,efficient mechanisms of risk transfer. when necessary, to prevent emergence of self-6.2 The origin of the foreign exchange market in fulfilling speculative activities (Mohan, 2006a).India could be traced to the year 1978 when banks 6.5 Against the above background, this chapterin India were permitted to undertake intra-day trade attempts to analyse the role of the central bank inin foreign exchange. However, it was in the 1990s developing the foreign exchange market. Section Ithat the Indian foreign exchange market witnessed provides a brief review of different exchange ratefar reaching changes along with the shifts in the regimes being followed in emerging mar ketcurrency regime in India. The exchange rate of the economies (EMEs). Section II traces the evolution ofrupee, that was pegged earlier was floated partially India’s foreign exchange market in line with the shiftsin March 1992 and fully in March 1993 following the in India’s exchange rate policies in the post-recommendations of the Report of the High Level independence period from the pegged to the marketCommittee on Balance of Payments (Chairman: Dr.C. determined regime. Various regulatory and policyRangarajan). The unification of the exchange rate initiatives taken by the Reser ve Bank and thewas instrumental in developing a market-determined Government of India for developing the foreignexchange rate of the rupee and an important step in exchange market in the market determined set upthe progress towards current account convertibility, have also been highlighted. Section III presents awhich was achieved in August 1994. detailed overview of the current foreign exchange6.3 A further impetus to the development of the market structure in India. It also analyses the availableforeign exchange market in India was provided with market infrastructure in terms of market players,the setting up of an Exper t Group on Foreign trading platfor m, instr uments and settlementExchange Markets in India (Chairman: Shri O.P. mechanisms. Section IV assesses the performanceSodhani), which submitted its report in June 1995. of the Indian foreign exchange market in terms ofThe Group made several recommendations for liquidity and efficiency. The increase in turnover indeepening and widening of the Indian foreign both onshore and offshore markets is highlighted inexchange market. Consequently, beginning from this section. Empirical exercises have also beenJanuary 1996, wide-ranging reforms have been attempted to assess the behaviour of forward premia,undertaken in the Indian foreign exchange market. bid-ask spreads and mar ket tur nover. HavingAfter almost a decade, an Internal Technical Group delineated the mar ket profile, Section V thenon the Foreign Exchange Mar ket (2005) was discusses the journey of the Indian foreign exchangeconstituted to undertake a comprehensive review of market since the early 1990s, especially through
  2. 2. REPORT ON CURRENCY AND FINANCEperiods of volatility and its management by the (iii) reserves should at least be sufficient to take careauthorities. As central bank intervention has been an of fluctuations in capital flows and liquidity at riskimportant element of managing volatility in the foreign (Jalan, 2003).exchange market, its need and effectiveness in a 6.9 Broadly, the overall distribution of exchangemarket determined exchange rate and open capital rate regimes across the globe among main categoriesregime has been examined in Section VI. Section VII remained more or less stable during 2001-06, thoughmakes certain suggestions with a view to further there was a tendency for some countries to shiftdeepening the foreign exchange market so that it can across and within exchange regimes (Table 6.1). Asmeet the challenges of an integrated world. Section at end-April 2006, there were more floating regimesVIII sums up the discussions. (79 countries including 53 managed floats and 26 independent floats) than soft pegs (60 countries) orI. EXCHANGE RATE REGIMES IN EMERGING hard pegs (48 countries) (Exhibit VI.1). Managed MARKETS floats are found in all par ts of the globe, while6.6 The regulatory framework governing the conventional fixed pegs are mostly observed in theforeign exchange market and the operational freedom Middle East, the North Africa and parts of Asia. Onavailable to market participants is, to a large extent, the other hand, hard pegs are found primarily ininfluenced by the exchange rate regime followed by Europe, Sub-Saharan Africa (the CFA zones) andan economy. In this section, therefore, we take a look small island economies (for instance, in the Easternat the exchange rate regimes that the EMEs have Caribbean). While 20 countries moved from a softadopted during the 1990s. peg to a floating regime during the past four years, this was offset by a similar number of other countries6.7 The experience with capital flows in the abandoning the floating arrangements in favour of1990s has had an important bearing on the choice soft pegs.of the exchange rate regime by EMEs in recentyears. The emphasis on corner solutions - a fixed 6.10 The substantial movement between soft pegspeg a la the currency board without monetary policy and floating regimes suggests that floating is notindependence or a freely floating exchange rate necessarily a durable state, particularly for lower andretaining discretionary conduct of monetary policy - middle-income countries, whereas there appears tois distinctly on the decline. The trend seems to be be a greater state of flux between managed floatingclearly in favour of inter mediate regimes with and pegged arrangements in high-income features and with no fixed targets The frequency with which countries fall back to pegsfor the level of the exchange rate. after a relatively short spell in floating suggests that many countries face institutional and operational6.8 An impor tant feature of the conduct of constraints to floating. The preference for tightermonetary policy in recent years has been the foreign management seems to have intensified recently as aexchange market interventions either by the central number of countries have enjoyed strong externalbank on its own behalf or on behalf of public sector demand and capital inflows. Other notable trendsentities to ensure orderly conditions in markets and included a shift away from currency baskets, with theto fight extreme market turbulence (Box VI.1). US dollar remaining the currency of choice forBesides, EMEs, in general, have also been countries with hard pegs as well as soft pegs. Oneaccumulating foreign exchange reserves as an third of the dollar pegs are hard pegs and theinsurance against shocks. It is a combination of remaining are soft pegs. The choice of the US dollarthese strategies which will guide monetar y for countries with soft pegs reflects its continuedauthorities through the impossible trinity of a fixed importance as an invoicing currency and a high shareexchange rate, open capital account and an of trade with the US or other countries that peg toindependent monetary policy (Mohan, 2003). The the US dollar. The euro is the second most importantdebate on appropriate policies relating to foreign currency and serves as an exchange rate anchor forexchange markets has now converged around some countries in Europe and the CFA franc zone in Africa.generally accepted views: (i) exchange rates shouldbe flexible and not fixed or pegged; (ii) there is 6.11 During the last 15 years, there was acontinuing need for many emerging mar ket general tendency among the emerging marketeconomies to be able to inter vene or manage economies to adopt a more flexible exchange rateexchange rates- to some degree - if movements are regime (Table 6.2). In emerging Asia, there is a broadbelieved to be destablising in the short run; and consensus that the soft US dollar peg operated by a 212
  3. 3. FOREIGN EXCHANGE MARKET Box VI.1 Exchange Rate Regimes and Monetary Policy in EMEsEconomic literature suggests that, at an aggregated level, Table: Monetary Policy Framework - April 2006the adoption of more flexible exchange rate regimes in Exchange Rate Monetary InflationEmerging Market (EM) countries has been associated Anchor Aggregate Targetwith greater monetary policy independence. EM countries Targetwith exchange rate anchors are generally associated withpegged regimes. Here, the exchange rate serves as the Bulgaria Argentina Brazilnominal anchor or intermediate target of monetary policy. Ecuador China ChileAround 27 per cent of the EM countr ies followed Egypt Indonesia Colombiaexchange rate anchors at the end of April 2006 (Table). Hong Kong Tunisia Czech RepublicWhen the exchange rate is directly targeted in order to Malaysia Uruguay Hungaryachieve price stability, inter vention operations are Venezuela Koreaunsterilised with inter-bank interest rates adjusting fully. Morocco MexicoIn Singapore, while pursuing a target band for the Hungary Peruexchange rate is the major monetary policy instrument, Philippinesthe central bank’s decision on whether to sterilise Polandintervention is made with reference to conditions in the South Africadomestic markets 1 . ThailandIn other regimes, where the exchange rate is not the Turkeymonetar y policy anchor, any liquidity impact ofintervention that would cause a change in monetary Source : Annual Repor t on Exchange Arrangements andconditions is generally avoided. Most foreign exchange Exchange Restrictions, 2006, IMF.operations are sterilised. Interventions may also be used becomes important when movements in the exchangein coordination with changes in monetary policy, givingthe latter a greater room for manoeuvre. For example, rate inconsistent with economic fundamentals threatenwhere a change in monetar y policy is unexpected, to push inflation outside the target band. However, wheresurprising the market can erode confidence or destabilise the exchange rate is responding appropriately to a “real”the market. Intervention may help minimise the costs of shock, it may be necessary either to acknowledge thesurprising financial markets, allowing monetary policy expected departure from the inflation target for somegreater capacity to move ahead of market expectations. period of time or to offset the shock by altering monetary policy. Most of the countries with inflation targeting asAround 17 per cent of the EM countries have adopted the monetary policy regime have adopted independentmonetary aggregate target, most of which are associated floating as the exchange rate policy. Empirical evidencewith managed floating exchange rate regimes. In the case suggests that most emerging economies that moved toof a monetary aggregate target, the monetary authority a free float, introduced full-fledged inflation targeting onlyuses its instruments to achieve a target growth rate for a after a transition. There are other EM countries, viz.,monetary aggregate (reserve money, M1, M2, etc.), and Algeria, India, Romania, and Russia, which have nothe targeted aggregate becomes the nominal anchor or explicitly stated nominal anchor, but rather monitorintermediate target of monetary policy. various indicators in the conduct of monetary policy. InAround 43 per cent of the EM countries have adopted some of the EM countries, coordinating these policiesinflation targeting as their monetary policy regime, where may be more difficult because foreign exchangechanges in interest rates are the principal instruments operations are not the responsibility of the monetaryof monetary policy. Inflation targeting involves the public authority. In such instances, the maintenance of a closeannouncement of medium-term numerical targets for dialogue between the respective authorities is importantinflation with an institutional commitment by the monetary in avoiding any conflict arising between monetary andauthority to achieve these targets. Here, intervention exchange rate policies.1 EMEAP Study on Exchange Rate Regimes, June 2001.number of Asian countries contributed to the regional which continued with its currency boardfinancial crisis in 1997-98. Since the Asian financial arrangement, and China, which despite somecrisis, several Asian economies have adopted more adjustments, virtually maintained its exchange rateflexible exchange rate regimes except for Hong Kong, peg to the US dollar. After experiencing some 213
  4. 4. REPORT ON CURRENCY AND FINANCE Table 6.1: Evolution of Exchange Rate Regimes, 1996 - April 2006 (Number of countries; end-December data)Regime 1996 2001 2002 2003 2004 2005 2006 April1 2 3 4 5 6 7 8I. Hard Pegs 30 47 48 48 48 48 48 No separate legal tender 24 40 41 41 41 41 41 Currency board arrangements 6 7 7 7 7 7 7II. Soft Pegs 94 58 59 59 59 61 60 a. Conventional Pegged arrangements 50 42 46 46 48 49 49 Pegs to Single Currency 36 32 36 38 40 44 44 Pegs to Composite 14 10 10 8 8 5 5 b. Intermediate Pegs 44 16 13 13 11 12 11 Pegged within horizontal bands 18 5 5 4 5 6 6 Crawling Pegs 14 6 5 6 6 6 5 Crawling Bands 12 5 3 3 0 0 0III. Floating Regimes 60 81 80 80 80 78 79 Managed Floating 37 43 45 46 49 52 53 Independently Floating 23 38 35 34 31 26 26Note : To ensure comparability, all data are based on the current de facto methodology applied retroactively, unless otherwise specified.Source : Annual Report on Exchange Arrangements and Exchange Restrictions, 2006, IMF and other sources.transitional regime, Malaysia started pegging to the Singapore dollar against an undisclosed basket ofUS dollar on September 1, 1998, but shifted over currencies of Singapore’s major trading partners andrecently (July 2005) to a managed float regime. In competitors. The Taiwanese government replaced itscontrast, Thailand, Indonesia, Korea, the Philippines earlier managed foreign exchange rate by a floatingand Taiwan have floated their currencies since the rate in 1989, consequent to an increase in its tradecrisis, while adopting a monetary policy strategy surplus and the resulting rise in the foreign exchangebased on inflation targeting. The Monetary Authority reserves.of Singapore (MAS) continues to monitor the 214
  5. 5. FOREIGN EXCHANGE MARKET Table 6.2: Emerging Market Countries: 6.13 An analysis of the complexities, challenges Transition to More Flexible Exchange Rate and vulnerabilities faced by EMEs in the conduct of Regimes: 1990 - April 2006 exchange rate policy and managing volatilities in foreign exchange market reveal that the choice of aTransition Type Country particular exchange rate regime alone cannot meet1 2 all the requirements. The emerging consensus is that for successful conduct of exchange rate policy, it isMove towards a more flexible Algeria Korea essential for countries to pursue sound and credibleexchange rate regime Argentina Mexico macroeconomic policies so as to avoid the build-up Brazil Peru of major macro imbalances in the economy. Second, Chile Poland it is essential for EMEs to improve the flexibility of Colombia Romania their product and factor markets in order to cope and Czech Republic Russia adjust to shocks arising from the volatility of currency Egypt Slovakia markets and swings in the terms of trade in world India Thailand product markets. Third, it is crucial for EMEs to Indonesia Turkey develop and strengthen their financial systems inMove towards a less flexible China Uruguay order to enhance their resilience to shocks. In addition,exchange rate regime Malaysia a sound and efficient banking system together with Hong Kong deep and liquid capital market contributes to the Ecuador efficient intermediation of financial flows. This could Venezuela help prevent the emergence of vulnerabilities in the Bulgaria financial system by minimising unsound lending practices that lead to the build-up of excessiveNote : The Classification of the countries’ exchange rate leveraging in the corporate sector and exposure to regimes is based on the IMF’s de facto classification foreign currency borrowings. Fourth, countries would and does not necessarily represent the views of the need to build regulatory and supervisory capabilities authorities. to keep pace with financial innovations and theSource : Annual Repor t on Exchange Arrangements and emergence of new financial institutions’ activities, and Exchange Restrictions, IMF, various issues. new products and services, which have complicated the conduct of exchange rate policy. Fifth, policy makers need to promote greater disclosures and6.12 Most of the Latin American economies have transparency.a history of very high inflation rates. As such, inflationcontrol has been a major objective of exchange rate 6.14 Fur ther more, the perception about thepolicies of these countries in recent years. Starting volatility and flexibility in exchange rate is contextual.from the end of 1994, a floating rate policy was What may be perceived as flexible for somemaintained in Mexico, with the Bank of Mexico economies may turn out to be volatile for otherintervening in the foreign exchange market under economies. The level of development andexceptional circumstances to minimise volatility and preparedness of financial markets and their risk-ensure an orderly market. Chile adopted exchange taking ability is crucial in this context (Reddy, 2007).rate flexibility in 1999, after experiencing an exchange If the level of development and preparedness ofrate band for the previous 17 years starting from 1982. financial markets is low, a small movement inAfter pursuing various forms of exchange rate pegs exchange rate could be interpreted as volatile, whilefor more than four decades, which included occasional even large movement in exchange rate in developeddevaluation as also a change of the currency, foreign exchange markets may not be seen asArgentina had to finally move away from its currency volatile. Thus, as financial markets develop in anboard linked to the US dollar in January 2002. Brazil, emerging economy, the tolerance to volatilityafter having a floating exchange rate regime with improves and hence what was once volatility wouldminor inter ventions in 1990s, adopted an later become flexibility. A key issue, therefore, forindependently floating exchange rate regime in the the authorities is where and when to make policyaftermath of its currency crisis in 19992. adjustments, including the use of official intervention2 Brazil had an adjustable band during 1995 to 1999 in a programme to control money creation. 215
  6. 6. REPORT ON CURRENCY AND FINANCEto help avoid substantial volatility and serious impact on price discovery, expor t performance,misalignments. sustainability of current account balance, and balance sheets in view of dollarisation. The EMEs’6.15 With gradual liberalisation and opening up experience has highlighted the need for developingof the capital account, capital flows to EMEs, countries to allow greater flexibility in exchangepar ticular ly to Asian economies increased rates. However, the authorities also need to havesignificantly dur ing the 1990s, posing new the capacity to inter vene in foreign exchangechallenges for central banks. Surges in capital flows markets in view of herd behaviour. With progressiveand their associated volatility have implications for opening of the emerging markets to financial flows,the conduct of monetary policy by central banks. The capital flows are playing an increasingly importantchallenges facing central banks pertain to liquidity role in exchange rate determination and are oftenmanagement, exchange rate and foreign exchange reflected in higher exchange rate volatility. Againstreser ve management. Central banks in these this backdrop, it would be appropriate to have a peepeconomies, thus, need to be equipped to deal with into the exchange rate regime followed in India andlarge capital flows. Since capital flows in some the evolution of foreign exchange market in the postcountries in recent years have been associated with independence period.various crises, there is also a rethinking aboutunfettered capital account liberalisation. II. INDIAN FOREIGN EXCHANGE MARKET:6.16 Intervention by most Asian central banks in A HISTORICAL PERSPECTIVEforeign exchange markets has become necessary Early Stages: 1947-1977from time to time primarily because of the growingimportance of capital flows in determining exchange 6.18 The evolution of India’s foreign exchangerate movements in these economies as against trade market may be viewed in line with the shifts in India’sdeficits and economic growth, which were important exchange rate policies over the last few decades fromin the earlier days. The latter does matter, but only a par value system to a basket-peg and further to aover a period (Jalan, 2003). On a day-to-day basis, it managed float exchange rate system. During theis capital flows, which influence the exchange rate period from 1947 to 1971, India followed the par valueand interest rate arithmetic of financial markets. system of exchange rate. Initially the rupee’s externalCapital movements have also rendered exchange par value was fixed at 4.15 grains of fine gold. Therates significantly more volatile than before (Mohan, Reserve Bank maintained the par value of the rupee2003). For the relatively open economies, this raises within the permitted margin of ±1 per cent usingthe issue of appropriate monetary policy response to pound sterling as the intervention currency. Since thesharp exchange rate movements since exchange rate sterling-dollar exchange rate was kept stable by thevolatility has had significant real effects in terms of US monetary authority, the exchange rates of rupeefluctuations in employment and output and the in terms of gold as well as the dollar and otherdistribution of activity between tradable and non- currencies were indirectly kept stable. Thetradable, especially in the developing countries, which devaluation of rupee in September 1949 and Junedepend on export performance as a key to the health 1966 in terms of gold resulted in the reduction of theof their balance of payments. In the fiercely par value of rupee in terms of gold to 2.88 and 1.83competitive trading environment, countries seek to grains of fine gold, respectively. The exchange rateexpand market shares aggressively by paring down of the rupee remained unchanged between 1966margins. In such cases even a small change in and 1971 (Chart VI.1).exchange rates can develop into significant and 6.19 Given the fixed exchange regime during thispersistent real effects. Thus, in order to benefit from period, the foreign exchange market for all practicalinternational capital inflows, host countries need to pur poses was defunct. Banks were required topursue sound macroeconomic policies, develop undertake only cover operations and maintain astrong institutions, and adopt appropriate regulatory ‘square’ or ‘near square’ position at all times. Theframeworks for the stability of financial systems and objective of exchange controls was primarily tosustained economic progress. regulate the demand for foreign exchange for various6.17 To sum up, while some flexibility in foreign purposes, within the limit set by the available markets and exchange rate determination The Foreign Exchange Regulation Act initiallyis desirable, excessive volatility can have adverse enacted in 1947 was placed on a permanent basis 216
  7. 7. FOREIGN EXCHANGE MARKET Formative Period: 1978-1992 6.21 The impetus to trading in the foreign exchange market in India came in 1978 when banks in India were allowed by the Reser ve Bank to undertake intra-day trading in foreign exchange and were required to comply with the stipulation of maintaining ‘square’ or ‘near square’ position only at the close of business hours each day. The extent of position which could be left uncovered overnight (the open position) as well as the limits up to which dealers could trade during the day were to be decided by the management of banks. The exchange rate of the rupee during this period was officially determined by the Reserve Bank in terms of a weighted basket of currencies of India’s major trading partners and the exchange rate regime was characterised by daily announcement by the Reserve Bank of its buying and selling rates to the Authorised Dealers (ADs) for under taking merchant transactions. The spread between the buying and the selling rates was 0.5 per cent and the market began to trade actively withinin 1957. In terms of the provisions of the Act, the this range. ADs were also permitted to trade in crossReserve Bank, and in certain cases, the Central currencies (one convertible foreign currency versusGovernment controlled and regulated the dealings another). However, no ‘position’ in this regard couldin foreign exchange payments outside India, export originate in overseas markets.and import of currency notes and bullion, transfers 6.22 As opportunities to make profits began toof securities between residents and non-residents, emerge, major banks in India started quoting two-acquisition of foreign securities, etc 3 . way prices against the rupee as well as in cross6.20 With the breakdown of the Bretton Woods currencies and, gradually, trading volumes began toSystem in 1971 and the floatation of major increase. This led to the adoption of widely differentcurrencies, the conduct of exchange rate policy practices (some of them being irregular) and theposed a serious challenge to all central banks world need was felt for a comprehensive set of guidelineswide as currency fluctuations opened up tremendous for operation of banks engaged in foreign exchangeopportunities for market players to trade in currencies business. Accordingly, the ‘Guidelines for Internalin a borderless market. In December 1971, the rupee Control over Foreign Exchange Business’, werewas linked with pound sterling. Since sterling was framed for adoption by the banks in 1981. The foreignfixed in terms of US dollar under the Smithsonian exchange market in India till the early 1990s,Agreement of 1971, the rupee also remained stable however, remained highly regulated with restrictionsagainst dollar. In order to overcome the weaknesses on external transactions, barriers to entr y, lowassociated with a single currency peg and to ensure liquidity and high transaction costs. The exchangestability of the exchange rate, the rupee, with effect rate during this period was managed mainly forfrom September 1975, was pegged to a basket of facilitating India’s impor ts. The strict control oncurrencies. The currency selection and weights foreign exchange transactions through the Foreignassigned were left to the discretion of the Reserve Exchange Regulations Act (FERA) had resulted inBank. The currencies included in the basket as well one of the largest and most efficient parallel marketsas their relative weights were kept confidential in for foreign exchange in the world, i.e., the hawalaorder to discourage speculation. It was around this (unofficial) market.time that banks in India became interested in trading 6.23 By the late 1980s and the early 1990s, it wasin foreign exchange. recognised that both macroeconomic policy and3 The Act was later replaced by a more comprehensive legislation, i.e., the Foreign Exchange Regulation Act, 1973. 217
  8. 8. REPORT ON CURRENCY AND FINANCEstructural factors had contributed to balance of put in place in March 1992 initially involving a dualpayments difficulties. Devaluations by India’s exchange rate system. Under the LERMS, all foreigncompetitors had aggravated the situation. Although exchange receipts on current account transactionsexports had recorded a higher growth during the (expor ts, remittances, etc.) were required to besecond half of the 1980s (from about 4.3 per cent surrendered to the Authorised Dealers (ADs) in full.of GDP in 1987-88 to about 5.8 per cent of GDP in The rate of exchange for conversion of 60 per cent of1990-91), trade imbalances persisted at around 3 per the proceeds of these transactions was the marketcent of GDP. This combined with a precipitous fall in rate quoted by the ADs, while the remaining 40 perinvisible receipts in the form of private remittances, cent of the proceeds were converted at the Reservetravel and tourism earnings in the year 1990-91 led Bank’s official rate. The ADs, in turn, were requiredto further widening of current account deficit. The to surrender these 40 per cent of their purchase ofweaknesses in the external sector were accentuated foreign currencies to the Reserve Bank. They wereby the Gulf crisis of 1990-91. As a result, the current free to retain the balance 60 per cent of foreignaccount deficit widened to 3.2 per cent of GDP in exchange for selling in the free market for permissible1990-91 and the capital flows also dr ied up transactions. The LERMS was essentially anecessitating the adoption of exceptional corrective transitional mechanism and a downward adjustmentsteps. It was against this backdrop that India in the official exchange rate took place in earlyembarked on stabilisation and structural reforms in December 1992 and ultimate convergence of the dualthe early 1990s. rates was made effective from March 1, 1993, leading to the introduction of a market-determined exchangePost-Reform Period: 1992 onwards rate regime.6.24 This phase was marked by wide ranging 6.26 The dual exchange rate system was replacedreform measures aimed at widening and deepening by a unified exchange rate system in March 1993,the foreign exchange market and liberalisation of whereby all foreign exchange receipts could beexchange control regimes. A credible converted at market determined exchange rates. Onmacroeconomic, str uctural and stabilisation unification of the exchange rates, the nominalprogramme encompassing trade, industry, foreign exchange rate of the rupee against both the US dollarinvestment, exchange rate, public finance and the as also against a basket of currencies got adjustedfinancial sector was put in place creating an lower, which almost nullified the impact of the previousenvironment conducive for the expansion of trade inflation differential. The restrictions on a number ofand investment. It was recognised that trade policies,exchange rate policies and industrial policies should other current account transactions were relaxed. Theform par t of an integrated policy framework to unification of the exchange rate of the Indian rupeeimprove the overall productivity, competitiveness and was an impor tant step towards current accountefficiency of the economic system, in general, and convertibility, which was finally achieved in Augustthe external sector, in particular. 1994, when India accepted obligations under Article VIII of the Articles of Agreement of the IMF.6.25 As a stabilsation measure, a two stepdownward exchange rate adjustment by 9 per cent 6.27 With the rupee becoming fully convertible onand 11 per cent between July 1 and 3, 1991 was all current account transactions, the risk-bearingresorted to counter the massive drawdown in the capacity of banks increased and foreign exchangeforeign exchange reserves, to instill confidence trading volumes star ted r ising. This wasamong investors and to improve domestic supplemented by wide-ranging reforms undertakencompetitiveness. A two-step adjustment of exchange by the Reser ve Bank in conjunction with therate in July 1991 effectively brought to close the Government to remove market distor tions andregime of a pegged exchange rate. After the Gulf deepen the foreign exchange market. The processcrisis in 1990-91, the broad framework for reforms in has been marked by ‘gradualism’ with measuresthe external sector was laid out in the Report of the being undertaken after extensive consultations withHigh Level Committee on Balance of Payments experts and market participants. The reform phase(Chair man: Dr. C. Rangarajan). Following the began with the Sodhani Committee (1994) which inrecommendations of the Committee to move towards its repor t submitted in 1995 made severalthe market-determined exchange rate, the Liberalised recommendations to relax the regulations with a viewExchange Rate Management System (LERMS) was to vitalising the foreign exchange market (Box VI.2). 218
  9. 9. FOREIGN EXCHANGE MARKET Box VI.2 Recommendations of the Expert Group on Foreign Exchange Markets in IndiaThe Expert Group on Foreign Exchange Markets in India recommended included exemption of domestic inter-(Chairman: Shri O.P.Sodhani), which submitted its Report bank borrowings from SLR/CRR requirements toin 1995, identified various regulations inhibiting the facilitate development of the ter m money mar ket,growth of the market. The Group recommended that the cancellation and re-booking of currency options,corporates may be permitted to take a hedge upon permission to offer lower cost option strategies such asdeclaring the existence of an exposure. The Group the ‘range forward’ and ‘ratio range forward’ and permittingrecommended that banks should be permitted to fix their ADs to offer any derivative products on a fully coveredown exchange position limits such as intra-day and basis which can be freely used for their own asset liabilityovernight limits, subject to ensuring that the capital is management.provided/earmarked to the extent of 5 per cent of thislimit based on internationally accepted guidelines. The As part of long-term measures, the Group suggestedGroup also favoured fixation of Aggregate Gap Limit that the Reserve Bank should invite detailed proposals(AGL), which would also include rupee transactions, by from banks for offering rupee-based derivatives, shouldthe managements of the banks based on capital, risk refocus exchange control regulation and guidelines ontaking capacity, etc. It recommended that banks be risks rather than on products and frame a fresh set ofallowed to initiate cross currency positions abroad and guidelines for foreign exchange and derivatives riskto lend or borrow short-term funds up to six months, management.subject to a specified ceiling. Another impor tantsuggestion related to allowing exporters to retain 100 As regards accounting and disclosure standards, theper cent of their export earnings in any foreign currency main recommendations included reviewing of policywith an Authorised Dealer (AD) in India, subject to procedures and transactions on an on-going basis by aliquidation of outstanding advances against export bills. risk control team independent of dealing and settlementThe Group was also in favour of permitting ADs to functions, ensuring of uniform documentation and marketdetermine the interest rates and maturity period in practices by the Foreign Exchange Dealers’ Associationrespect of FCNR (B) deposits. It recommended selective of India (FEDAI) or any other body and development ofintervention by the Reserve Bank in the market so as to accounting disclosure standards.ensure greater orderliness in the market. Reference:In addition, the Group recommended various other short-term and long-term measures to activate and facilitate Reser ve Bank of India. 1995. Repor t on Foreignfunctioning of markets and promote the development Exchange Mar kets in India (Chair man : Shr i O.Pof a vibrant derivative market. Shor t-term measures Sodhani), June.Most of the recommendations of the Sodhani recommendations such as freedom to cancel andCommittee relating to the development of the foreign rebook forward contracts of any tenor, delegation ofexchange market were implemented during the latter powers to ADs for grant of permission to corporateshalf of the 1990s. to hedge their exposure to commodity price risk in6.28 In addition, several initiatives aimed at the international commodity exchanges/markets anddismantling controls and providing an enabling extension of the trading hours of the inter-bankenvironment to all entities engaged in foreign foreign exchange mar ket have since beenexchange transactions have been undertaken since implemented.the mid-1990s. The focus has been on developing the 6.30 Along with these specific measures aimed atinstitutional framework and increasing the instruments developing the foreign exchange market, measuresfor effective functioning, enhancing transparency and towards liberalising the capital account were alsoliberalising the conduct of foreign exchange business implemented during the last decade, guided to a largeso as to move away from micro management of extent since 1997 by the Report of the Committee onforeign exchange transactions to macro management Capital Account Convertibility (Chairman: Shri S.S.of foreign exchange flows (Box VI.3). Tarapore). Various reform measures since the early6.29 An Internal Technical Group on the Foreign 1990s have had a profound effect on the marketExchange Markets (2005) set up by the Reserve structure, depth, liquidity and efficiency of the IndianBank made various recommendations for further foreign exchange market as detailed in the followingliberalisation of the extant regulations. Some of the section. 219
  10. 10. REPORT ON CURRENCY AND FINANCE Box VI.3 Measures Initiated to Develop the Foreign Exchange Market in IndiaInstitutional Framework exemption of inter-bank borrowings from statutory pre- emptions; and (iii) use derivative products for asset-• The Foreign Exchange Regulation Act (FERA), 1973 liability management. was replaced by the market friendly Foreign Exchange Management Act (FEMA), 1999. The Reserve Bank • Participants in the foreign exchange market, including delegated powers to authorised dealers (ADs) to exporters, Indians investing abroad, and FIIs were release foreign exchange for a variety of purposes. permitted to avail forward cover and enter into swap transactions without any limit, subject to genuine• In pursuance of the Sodhani Committee’s underlying exposure. recommendations, the Clearing Corporation of India Limited (CCIL) was set up in 2001. • FIIs and NRIs were permitted to trade in exchange- traded der ivative contracts, subject to cer tain• To further the participatory process in a more holistic conditions. manner by taking into account all segments of the financial markets, the ambit of the Technical Advisory • Foreign exchange earners were permitted to maintain Committee (TAC) on Money and Securities Markets foreign currency accounts. Residents were permitted set up by the Reserve Bank in 1999 was expanded in to open such accounts within the general limit of US $ 2004 to include foreign exchange markets and the 25,000 per year, which was raised to US $ 50,000 per Committee was rechristened as TAC on Money, year in 2006, has further increased to US $ 1,00,000 Gover nment Secur ities and Foreign Exchange since April 2007. Markets. Disclosure and Transparency InitiativesIncrease in Instruments in the Foreign Exchange • The Reserve Bank has been taking initiatives in puttingMarket in public domain all data relating to foreign exchange• The rupee-foreign currency swap market was allowed. market transactions and operations. The Reserve Bank disseminates: (a) daily reference rate which is an• Additional hedging instruments such as foreign indicative rate for market observers through its website, currency-rupee options, cross-currency options, (b) data on exchange rates of rupee against some interest rate swaps (IRS) and currency swaps, caps/ major currencies and foreign exchange reserves on a collars and forward rate agreements (FRAs) were weekly basis in the Weekly Statistical Supplement introduced. (WSS), and (c) data on purchases and sales of foreign currency by the Reserve Bank in its Monthly Bulletin.Liberalisation Measures The Reserve Bank has already achieved full disclosure of information pertaining to international reserves and• Authorised dealers were permitted to initiate trading foreign currency liquidity position under the Special positions, borrow and invest in overseas market, Data Dissemination Standards (SDDS) of the IMF. subject to certain specifications and ratification by respective banks’ Boards. Banks were also permitted Reference: to (i) fix net overnight position limits and gap limits (with the Reserve Bank formally approving the limits); Mohan, Rakesh. 2006. “Financial Sector Reforms and (ii) determine the interest rates (subject to a ceiling) Monetary Policy: The Indian Experience.” RBI Bulletin, and matur ity per iod of FCNR(B) deposits with July.III. FOREIGN EXCHANGE MARKET STRUCTURE to look at exchange rate movements as a source of return without adopting appropriate risk managementMarket Segments practices. This, at times, creates uneven supply-6.31 Foreign exchange market activity in most demand conditions, often based on ‘‘news and views’’.EMEs takes place onshore with many countries Though most of the emerging market countries allowprohibiting onshore entities from undertaking the operations in the forward segment of the market, it isoperations in offshore markets for their currencies. still underdeveloped in most of these economies. TheSpot market is the predominant form of foreign lack of forward market development reflects manyexchange mar ket segment in developing and factors, including limited exchange rate flexibility, theemerging market countries. A common feature is the de facto exchange rate insurance provided by thetendency of importers/exporters and other end-users central bank through interventions, absence of a yield 220
  11. 11. FOREIGN EXCHANGE MARKETcurve on which to base the forward prices and shallow exchange, (b) foreign exchange brokers who act asmoney markets, in which market-making banks can intermediaries, and (c) customers – individuals,hedge the maturity risks implicit in forward positions corporates, who need foreign exchange for their(Canales-Kriljenko, 2004). transactions. Though customers are major players in the foreign exchange market, for all practical purposes6.32 Most foreign exchange markets in developing they depend upon ADs and brokers. In the spot foreigncountries are either pure dealer markets or a exchange market, foreign exchange transactions werecombination of dealer and auction markets. In the earlier dominated by brokers. Nevertheless, thedealer markets, some dealers become market makers situation has changed with the evolving marketand play a central role in the determination of conditions, as now the transactions are dominatedexchange rates in flexible exchange rate regimes. by ADs. Brokers continue to dominate the derivativesMarket makers set two-way exchange rates at which market.they are willing to deal with other dealers. The bid-offer spread reflects many factors, including the level 6.35 The Reserve Bank intervenes in the marketof competition among market makers. In most of the essentially to ensure orderly market conditions. TheEMEs, a code of conduct establishes the principles Reserve Bank undertakes sales/purchases of foreignthat guide the operations of the dealers in the foreign currency in periods of excess demand/supply in theexchange mar kets. It is the central bank, or market. Foreign Exchange Dealers’ Association ofprofessional dealers association, which normally India (FEDAI) plays a special role in the foreignissues the code of conduct (Canales-Kriljenko, 2004). exchange market for ensuring smooth and speedyIn auction mar kets, an auctioneer or auction growth of the foreign exchange market in all itsmechanism allocates foreign exchange by matching aspects. All ADs are required to become members ofsupply and demand orders. In pure auction markets, the FEDAI and execute an undertaking to the effectorder imbalances are cleared only by exchange rate that they would abide by the terms and conditionsadjustments. Pure auction market structures are, stipulated by the FEDAI for transacting foreignhowever, now rare and they generally prevail in exchange business. The FEDAI is also the accreditingcombination with dealer markets. authority for the foreign exchange brokers in the inter-6.33 The Indian foreign exchange market is a bank foreign exchange market.decentralised multiple dealership market comprising 6.36 The licences for ADs are issued to banks andtwo segments – the spot and the derivatives market. other institutions, on their request, under SectionIn the spot market, currencies are traded at the 10(1) of the Foreign Exchange Management Act,prevailing rates and the settlement or value date is 1999. ADs have been divided into different categories.two business days ahead. The two-day period gives All scheduled commercial banks, which include publicadequate time for the parties to send instructions to sector banks, private sector banks and foreign banksdebit and credit the appropriate bank accounts at operating in India, belong to category I of ADs. Allhome and abroad. The der ivatives mar ket upgraded full fledged money changers (FFMCs) andencompasses forwards, swaps and options. Though select regional rural banks (RRBs) and co-operativeforward contracts exist for maturities up to one year, banks belong to category II of ADs. Select financialmajority of forward contracts are for one month, three institutions such as EXIM Bank belong to categorymonths, or six months. Forward contracts for longer III of ADs. Currently, there are 86 (Category I) ADsper iods are not as common because of the operating in India out of which five are co-operativeuncertainties involved and related pricing issues. A banks (Table 6.3). All merchant transactions in theswap transaction in the foreign exchange market is a foreign exchange market have to be necessarilycombination of a spot and a forward in the opposite undertaken directly through ADs. However, to providedirection. As in the case of other EMEs, the spot depth and liquidity to the inter-bank segment, ADsmarket is the dominant segment of the Indian foreign have been permitted to utilise the services of brokersexchange market. The derivative segment of the for better pr ice discover y in their inter-bankforeign exchange market is assuming significance and transactions. In order to further increase the size ofthe activity in this segment is gradually rising. the foreign exchange market and enable it to handle large flows, it is generally felt that more ADs shouldMarket Players be encouraged to participate in the market making.6.34 Players in the Indian market include (a) ADs, The number of participants who can give two-waymostly banks who are authorised to deal in foreign quotes also needs to be increased. 221
  12. 12. REPORT ON CURRENCY AND FINANCE Table 6.3: Authorised Dealers (Category-I) in the account transactions dominated the foreign exchange Foreign Exchange Market market. The behaviour as well as the incentive (As on March 31, 2007) structure of the participants who use the market for current account transactions differ significantly fromCategory Number those who use the foreign exchange market for capital1 2 account transactions. Besides, the change in thesePublic Sector Banks 27 traditional determinants has also reflected itself inPrivate Sector Banks 31 enhanced volatility in currency markets. It nowOf which: appears that expectations and even momentary Co-operative Banks 5 reactions to the news are often more important inForeign Banks 28 determining fluctuations in capital flows and hence itTotal 86 serves to amplify exchange rate volatility (Mohan, 2006a). On many occasions, the pressure onSource : Reserve Bank of India. exchange rate through increase in demand emanates from “expectations based on cer tain news”.6.37 The customer segment of the foreign Sometimes, such expectations are destabilising andexchange market comprises major public sector units, often give rise to self-fulfilling speculative activities.cor porates and business entities with foreign Recognising this, increased emphasis is being placedexchange exposure. It is generally dominated by on the management of capital account throughselect large public sector units such as Indian Oil management of foreign direct investment, portfolioCorporation, ONGC, BHEL, SAIL, Maruti Udyog and investment, external commercial borrowings, non-also the Government of India (for defence and civil resident deposits and capital outflows. However, theredebt service) as also big private sector corporates are occasions when large capital inflows as also largelike Reliance Group, Tata Group and Larsen and lumpiness in demand do take place, in spite ofToubro, among others. In recent years, foreign adhering to all the tools of management of capitalinstitutional investors (FIIs) have emerged as major account. The role of the Reserve Bank comes intoplayers in the foreign exchange market. focus during such times when it has to prevent the emergence of such destabilising expectations. In suchSources of Supply and Demand in the Foreign cases, recourse is undertaken to direct purchase andExchange Market sale of foreign currencies, sterilisation through open6.38 The major sources of supply of foreign market operations, management of liquidity underexchange in the Indian foreign exchange market are liquidity adjustment facility (LAF), changes in reservereceipts on account of exports and invisibles in the requirements and signaling through interest ratecurrent account and inflows in the capital account changes. In the last few years, despite large capitalsuch as foreign direct investment (FDI), portfolio inflows, the rupee has shown two - way movements.investment, external commercial borrowings (ECB) Besides, the demand/supply situation is also affectedand non-resident deposits. On the other hand, the by hedging activities through various instruments thatdemand for foreign exchange emanates from imports have been made available to market participants toand invisible payments in the current account, hedge their risks.amortisation of ECB (including shor t-term tradecredits) and external aid, redemption of NRI deposits Derivative Market Instrumentsand outflows on account of direct and por tfolio 6.40 Derivatives play a crucial role in developinginvestment. In India, the Government has no foreign the foreign exchange market as they enable marketcurrency account, and thus the external aid received players to hedge against underlying exposures andby the Government comes directly to the reserves shape the overall risk profile of participants in theand the Reserve Bank releases the required rupee market. Banks in India have been increasingly usingfunds. Hence, this particular source of supply of derivatives for managing risks and have also beenforeign exchange is not routed through the market offering these products to corporates. In India, variousand as such does not impact the exchange rate. informal forms of derivatives contracts have existed6.39 During last five years, sources of supply and for a long time though the formal introduction of ademand have changed significantly, with large variety of instruments in the foreign exchangetransactions emanating from the capital account, derivatives market started only in the post-reformunlike in the 1980s and the 1990s when current period, especially since the mid-1990s. Cross- 222
  13. 13. FOREIGN EXCHANGE MARKETcurrency derivatives with the rupee as one leg were the farther segment of corporates such as small andintroduced with some restrictions in April 1997. medium enterprises (SME) sector, it is imperative thatRupee-foreign exchange options were allowed in July public sector banks develop the necessar y2003. The foreign exchange derivative products that infrastructure and expertise to transact in options. Inare now available in Indian financial markets can be view of the growing complexity, diversity and volumegrouped into three broad segments, viz., forwards, of derivatives used by banks, an Internal Group wasoptions (foreign currency rupee options and cross constituted by the Reserve Bank to review the existingcurrency options) and currency swaps (foreign guidelines on der ivatives and for mulatecurrency rupee swaps and cross currency swaps) comprehensive guidelines on derivatives for banks(Box VI.4). (Box VI.5).6.41 Available data indicate that the most widely 6.42 With regard to forward contracts and swaps,used derivative instruments are the forwards and which are relatively more popular instruments in theforeign exchange swaps (rupee-dollar). Options have Indian derivatives market, cancellation and rebookingalso been in use in the market for the last four years. of forward contracts and swaps in India have beenHowever, their volumes are not significant and bid- regulated. Gradually, however, the Reserve Bank hasoffer spreads are quite wide, indicating that the market been taking measures towards eliminating suchis relatively illiquid. Another major factor hindering the regulations. The objective has been to ensure thatdevelopment of the options market is that corporates excessive cancellation and rebooking do not add toare not permitted to write/sell options. If corporates the volatility of the rupee. At present, exposureswith underlying exposures are permitted to write/sell arising on account of swaps, enabling a corporate tocovered options, this would lead to increase in market move from rupee to foreign currency liability (derivedvolume and liquidity. Further, very few banks are exposures), are not permitted to be hedged. Whilemarket makers in this product and many deals are the market participants have preferred such a hedgingdone on a back to back basis. For the product to reach facility, it is generally believed that equating derived Box VI.4 Foreign Exchange Derivative Instruments in India Foreign Exchange Forwards sell foreign currency rupee options to their customers on a back-to-back basis, provided they have a capital to risk- Authorised Dealers (ADs) (Category-I) are permitted to weighted assets ratio (CRAR) of 9 per cent or above. These issue forward contracts to persons resident in India with options are used by customers who have genuine foreign crystallised foreign currency/foreign interest rate exposure currency exposures, as permitted by the Reserve Bank and based on past performance/actual import-export and by ADs (Category-I) for the purpose of hedging trading turnover, as permitted by the Reserve Bank and to persons books and balance sheet exposures. resident outside India with genuine currency exposure to the rupee, as permitted by the Reserve Bank. The residents Cross-Currency Options in India generally hedge crystallised foreign currency/ foreign interest rate exposure or transform exposure from ADs (Category-I) are permitted to issue cross-currency one currency to another permitted currency. Residents options to a person resident in India with crystallised foreign outside India enter into such contracts to hedge or currency exposure, as permitted by the Reserve Bank. The transform permitted foreign currency exposure to the clients use this instrument to hedge or transform foreign rupee, as permitted by the Reserve Bank. currency exposure arising out of current account transactions. ADs use this instrument to cover the risks arising out of Foreign Currency Rupee Swap market-making in foreign currency rupee options as well as A person resident in India who has a long-term foreign cross currency options, as permitted by the Reserve Bank. currency or rupee liability is permitted to enter into such a swap transaction with ADs (Category-I) to hedge or Cross-Currency Swaps transform exposure in foreign currency/foreign interest rate Entities with borrowings in foreign currency under external to rupee/rupee interest rate. commercial borrowing (ECB) are permitted to use cross currency swaps for transformation of and/or hedging Foreign Currency Rupee Options foreign currency and interest rate risks. Use of this product ADs (Category-I) approved by the Reserve Bank and ADs in a structured product not conforming to the specific (Category-I) who are not market makers are allowed to purposes is not permitted. 223
  14. 14. REPORT ON CURRENCY AND FINANCE Box VI.5 Derivatives Market: Comprehensive GuidelinesThe draft comprehensive guidelines issued on December 11, entail (i) appropriate oversight by the board of directors and2006 cover broad generic principles for undertaking derivative senior management; (ii) adequate risk management processtransactions, permissible categories of derivative instruments, that integrates prudent risk limits, sound measurementdefining the role of market makers and users, suitability and procedures and information systems, continuous riskappropriateness policies, risk management and corporate monitoring and frequent management repor ting; andgovernance aspects, and internal control and audit. (iii) comprehensive internal controls and audit procedures.Subsequently, a modified version of these guidelines Regarding risk management, the guidelines explainincorporating the comments of a wide spectrum of banks and identification and accurate measurement of various typesmarket participants was issued by the Reserve Bank on April of risks, by the market makers, involved in derivative20, 2007. These guidelines for accounting and valuation of activities. Accurate measurement of derivative relatedderivatives, already circulated, are expected to provide a risks is necessary for proper monitoring and control and,holistic framework for regulating the derivatives business of therefore, all significant risks should be measured andbanks in future. Comprehensive guidelines contain four main integrated into an entity-wide risk management system.modifications in the existing guidelines pertaining to The guidelines further elucidate various risk limits, viz.,instruments in foreign exchange derivatives. First, users such market risk limits, credit limits, and liquidity limits, whichas importers and exporters having crystallised unhedged serve as a means to control exposures to various risksexposure in respect of current account transactions may write associated with derivative activities. Apart from abovecovered call and put options in both foreign currency/rupee mentioned principles, the guidelines also include theand cross currency and receive premia. Second, market requirement of a mechanism for an independentmakers may write cross currency options. Third, market monitoring of each entity and controlling of various risksmakers may offer plain vanilla American foreign currency in derivatives. Furthermore, the guidelines cover detailsrupee options. Fourthly, a person resident in India having pertaining to internal audit, prudential norms relating toforeign exchange or rupee liability is permitted to enter into a derivatives, prudential limits on derivatives, and regulatoryforeign currency rupee swap for hedging long-term exposure, reporting and balance sheet disclosures.i.e., exposure with residual maturity of three years or more.For risk management and corporate governance related Reference:to banks’ exposure to derivatives markets, basic principlesof a prudent system have been specified in the Reserve Bank of India. 2006. Comprehensive Guidelinescomprehensive guidelines. These basic principles mainly on Derivatives Market.exposure in foreign currency with actual borrowing in Eligible limits were gradually raised to enableforeign currency would tantamount to violation of the corporates greater flexibility. The limits are computedbasic premise for accessing the forward foreign separately for export and import contracts. Documentsexchange market in India, i.e., having an underlying are required to be furnished at the time of maturity offoreign exchange exposure. the contract. Contracts booked in excess of 25 per cent of the eligible limit had to be on a deliverable6.43 This feature (i.e., ‘the role of an underlying basis and could not be cancelled. This relaxation hastransaction in the booking of a forward contract’) is proved very useful to exporters of software and otherunique to the Indian derivatives market. The insistence services since their projects are executed on the basison this requirement of underlying exposure has to be of master agreements with overseas buyers, whichviewed against the backdrop of the then prevailing usually do not indicate the volumes and tenor of theconditions when it was imposed. Corporates in India expor ts (Repor t of Inter nal Group on Foreignhave been permitted increasing access to foreign Exchange Markets, 2005). In order to provide greatercurrency funds since 1992. They were also accorded flexibility to exporters and importers, as announcedgreater freedom to under take active hedging. in the Mid-term review of the Annual Policy 2006-07,However, recognising the relatively nascent stage of this limit has been enhanced to 50 per cent.the foreign exchange market initially with the lack ofcapabilities to handle massive speculation, the 6.44 Notwithstanding the initiatives that have been‘underlying exposure’ criterion was imposed as a pre- taken to enhance the flexibility for the corporates, therequisite. Exporters and importers were permitted to need is felt to review the underlying exposure criteriabook forward contracts on the basis of a declaration for booking a forward contract. The underlyingof an exposure and on the basis of past performance. exposure criteria enable corporates to hedge only a 224
  15. 15. FOREIGN EXCHANGE MARKETpart of their exposures that arise on the basis of the and zinc in international commodity exchanges,physical volume of goods (exports/imports) to be based on their underlying economic exposures; anddelivered 4 . With the Indian economy getting (b) actual users of aviation turbine fuel (ATF) toincreasingly globalised, corporates are also exposed hedge their economic exposures in the internationalto a variety of ‘economic exposures’ associated with commodity exchanges based on their domesticthe types of foreign exchange/commodity risks/ purchases. Authorised dealer banks may approachexposures arising out of exchange rate fluctuations. the Reser ve Bank for per mission on behalf ofAt present, the domestic prices of commodities such customers who are exposed to systemic internationalas ferrous and non-ferrous metals, basic chemicals, price risk, not covered otherwise. In order to facilitatepetro-chemicals, etc. are observed to exhibit world dynamic hedging of foreign exchange exposures ofimport parity. Given the two-way movement of the exporters and importers of goods and services, itrupee against the US dollar and other currencies in has been proposed that forward contracts bookedrecent years, it is necessar y for the producer/ in excess of 75 per cent of the eligible limits have toconsumer of such products to hedge their economic be on a deliverable basis and cannot be cancelledexposures to exchange rate fluctuation. Besides, as against the existing limit of 50 per cent. With aprice-fix hedges are also available for traders globally. view to giving greater flexibility to corporates withThey enable importers/exporters to lock into a future overseas direct investments, the forward contractsprice for a commodity that they plan to import/export entered into for hedging overseas direct investmentswithout actually having a cr ystallised physical have been allowed to be cancelled and rebooked. Inexposure to the commodity. Traders may also be order to enable small and medium enterprises toaffected not only because of changes in rupee-dollar hedge their foreign exchange exposures, it has beenexchange rates but also because of changes in cross proposed to permit them to book forward contractscurrency exchange rates. The requirement of without underlying exposures or past records of‘underlying criteria’ is also often cited as one of the exports and imports. Such contracts may be bookedreasons for the lack of liquidity in some of the through ADs with whom the SMEs have creditderivative products in India. Hence, a fixation on the facilities. They have also been allowed to freely‘underlying criteria’ as India globalises may hinder the cancel and rebook these contracts. In order to enablefull development of the forward mar ket. The resident individuals to manage/hedge their foreignrequirement of past perfor mance/under lying exchange exposures, it has been proposed to permitexposures should be eliminated in a phased manner. resident individuals to book forward contracts withoutThis has also been the recommendation of both the production of underlying documents up to an annualcommittees on capital account convertibility. It is cited limit of US $ 100,000, which can be freely cancelledthat this pre-requisite has been one of the factors and rebooked.contributing to the shift over time towards the non-deliverable forward (NDF) market at offshore locationsto hedge such exposures since such requirement is Foreign Exchange Market Trading Platformnot stipulated while booking a NDF contract. An 6.46 A variety of trading platforms are used byattempt has been made recently provide importers dealers in the EMEs for communicating and tradingthe facility to partly hedge their economic exposure with one another on a bilateral basis. They conductby permitting them to book forward contracts for their bilateral trades through telephones that are latercustoms duty component. confirmed by fax or telex. Some dealers also trade6.45 The Annual Policy Statement for 2007-08, on electronic trading platforms that allow for bilateralreleased on April 24, 2007 announced a host of conversations and dealing such as the Reutersmeasures to expand the range of hedging tools Dealing 2000-1 and Dealing 3000 Spot systems.available to market participants as also facilitate Bilateral conversations may also take place overdynamic hedging by residents. To hedge economic networks provided by central banks and over privateexposures, it has been proposed that ADs (Category- sector networks (Brazil, Chile, Colombia, Korea andI) may permit (a) domestic producers/users to hedge the Philippines). Reuters’ Dealing System has beentheir price risk on aluminium, copper, lead, nickel the most popular trading platform in EMEs.4 These are generally categorised as ‘transactions exposure’ which is the extent to which the value of transactions already entered into is affected by exchange rate risk and ‘contractual exposure’ that connotes the extent of exposures associated with contractual agreements. 225