Currency futures now

Business Standard, 18 April 2007

India is stumbling into the world of financial globalisation without fully thinking through the financial and monetary economics. The INR is moving - as it should. The INR is becoming an international currency - as it should. A key missing link is the domestic currency futures market, where economic agents can control currency risk. This market is banned by RBI. This ban needs to be lifted right away. SEBI, NSE and BSE fully possess the knowledge and institutional capability to build a successful currency futures market, one which will assist all firms and households in dealing with currency risk.

In the conflict between inflation management and currency management, RBI made the right decision in thinking that inflation is the job of the central bank while the currency is the job of the market. Just as governments of mature market economies are spectators on the price formation of cement or steel or shares, they are mere spectators of price formation on the currency market. The job of a central bank is to focus on inflation. Inflation volatility affects the entire macroeconomy, while currency volatility only affects a few firms and can be substantially addressed by currency derivatives. Chasing currency targets is not worthwhile when it comes at a cost of control of inflation. An effort by RBI to stabilise the currency compromises the stabilising role that monetary policy can play for the domestic business cycle.

It is not yet known whether this will be a long term change in RBI's behaviour, or whether RBI will go back to its old ways in a few weeks. In 2004, there was a similar situation, where the currency policy of RBI became untenable. But after `letting off steam', they quietly went back to the old policies. As a consequence, the economy has lurched from extremes of a near-fixed exchange rate (e.g. February) followed by a highly-volatile exchange rate (e.g. March).

How might things play out? There are two possible scenarios. In one case, the erstwhile monetary policy regime is discarded. A superior monetary policy framework involves a continual stream of currency volatility. Currency volatility would not lurch from very low to very high - the currency would be adjusting all the time.

The other possibility is that nothing is done on reforming the monetary policy framework; the ancien regime is left intact. In a few weeks, RBI will be back to its old ways of trading on the currency market. Once again, the economy will be lulled into complacence with the false promise of a currency that RBI controls. This will not work: once again, at a future date, this promise will be violated by a burst of currency fluctuations, where RBI is forced to back away from currency trading because Parliament cares about inflation and not the exchange rate.

Hence, whether RBI reforms take place or not: the firms and households of India have a problem with currency risk. Currency fluctuations affect firms in far-reaching ways. At the simplest, firms that import and export through long term contracts face currency risk. Further, firms which borrow in foreign currency face currency risk. The most important currency risk comes through import parity pricing: this affects big and small firms all across the country. A firm that buys steel from a local producer is exposed to INR/USD fluctuations because the local price of steel is just the exchange rate multiplied by the world price of steel. Such firms are unfortunately banned from currency derivatives trading by existing RBI rules. Households who have shares in firms like Infosys are exposed to currency risk when Infosys carries unhedged currency risk.

The way forward lies in building a currency futures and options market. This would be a market where every Indian household and firm would be able to trade on futures and options on the INR/USD or the USD/JPY or the INR/CNY exchange rates. SEBI's regime of prudential regulation would apply - this involves requiring collateral from participants, and imposing position limits to prevent market power. As with the Nifty futures, it is easy to setup this market with settlement in Indian rupees, so there are no BOP implications. What the market constitutes is a domestic platform where the people who benefit when the rupee appreciates enter into contracts with the people who hurt when the rupee appreciates. These are the natural counterparties who insure each other.

All the institutional infrastructure that does futures and options trading on NSE and BSE is readily applied to currency futures trading. This includes electronic trading, a nationwide network of members of exchanges, Internet trading, novation at the clearing corporation, real-time VaR-based risk management, etc. Hence, the market can be started within roughly ten days of preparatory work.

A few years ago, the launch of the interest rate futures market was sabotaged by a ban on bank participation. A successful currency futures market requires vigilance against such tactics. The key places where the currency futures market can be undermined is the rules governing banks and FIIs.

A central bank running a pegged exchange rate - as RBI has been doing - constitutes a public sector risk management system. The central bank thinks it knows best what risk it can allow its flock to suffer from. This public sector risk management is untenable, for currency policy comes at the cost of inflation management, and every now and then, RBI has left its flock out in the cold.

Firms are outraged when, after a long period of being promised a managed exchange rate, they are suddenly subjected to price fluctuations. The way forward for firms is to recognise that in a democracy, a central bank cannot make a credible promise about currency management. Parliament will always overrule the central bank in demanding that inflation management take precedence over currency management.

The right path for the firms is to demand world-class markets - with transparency, liquidity and nationwide access - where futures and options trading on currencies is made available to them. It is better for each person to buy his own umbrella, and achieve protection against currency risk based on his own needs and circumstances, than ask for the government to build a giant umbrella of public sector risk management. INR currency futures will soon be trading in Dubai: surely Indian households and firms should have access to one such market too?

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