Slow, steady steps to CAC

Having been on a few RBI panels, I know that some of their recommendations, generally, take many moons to see the light of day, while others sink without a trace. More power then to the Task Force on Offshore Rupee Markets (chaired by ex-deputy governor, Usha Thorat), which delivered its report at the end of July 2019 and the impact of who’s recommendations are seen in the accompanying graphic. Clearly, the arbitrage, which excited many companies to even go so far as to set up off-shore subsidiaries, is dead. To be sure, this is directly because of RBI’s NDF Directions (of March 27), which permitted on-shore banks to access the NDF market, if they were set up in the IFSC. And, of course, the few banks which did jump in have been able to arbitrage away the gap between the two markets, achieving one of RBI’s goals—to reduce the role of off-shore markets in driving USD-INR price discovery and volatility.

It is important to recognise that up until 2019 the volume of INR NDF trades, at around $20 bn a day, was more or less on par with— indeed, a little higher than—the on-shore forward volumes. However, the bulk of NDF trades were at the shortest end—around 1 month forward—confirming the obvious that this was a purely speculative play and did not have substantial (at least relative to total volumes) corporate or investor hedging. Thus, as the arbitrage thins out, it is likely that the NDF volumes will also fall.

Of course, there will always be some real demand for NDFs from investors (looking to play the carry) and from entities with actual exposures to INR (for hedging). The Task Force has tried to address these issues by, for instance, recommending that banks in the IFSC be permitted to pass on gains on cancelled contracts even without an underlying, and recommending substantive changes in tax and KYC rules.

While all of the recommendations have not yet been implemented—the tax changes are outside RBI’s purview—it is clear that the ship is directed forward towards bringing the NDF market to India (but not on-shore) and towards greater capital account convertibility. Indeed, RBI Governor Das, at last week’s annual day function of the Foreign Exchange Dealers Association of India (FEDAI), spoke explicitly of “Capital Account Convertibility … a long term vision with short and medium term goals…” This, of course, had several media outlets once again wondering about whether more substantive changes were on the cards. To my mind, there are at least two areas that require fundamental change before we can consider ourselves even reasonably convertible on the capital account. The first is having wider participation in the FX market. In the global market that traded $6.6 tn (equivalent) a day in 2020, nearly 55% of the volumes were ascribed to “other financial institutions”, which are typically end-users of foreign exchange and interest rate derivatives. They mainly cover smaller commercial banks, investment banks and securities houses, and, in addition, mutual funds, pension funds, hedge funds, currency funds, money market funds, building societies, leasing companies, insurance companies, other financial subsidiaries of corporate firms and central banks. In India, where the daily FX turnover is around $30-40 bn a day, the share of “other financial institutions” is vanishingly small because on-shore entities other than authorised dealers are not permitted to participate in the FX market unless they have underlying exposures. One idea, which I have floated earlier, is to permit selected “other financial institutions” to access the FX market to a particular limit. This will, importantly, bring in different needs, and hence, different trading practices—PD’s, for instance, would be driven strictly by the arbitrage opportunity and would transact differently than bank (and other) trading desks, who would be playing on their views. This would increase both liquidity and volatility.

The second requirement is, to my mind, much more difficult in current circumstances. While the sovereign yield curve is now reasonably well developed, secondary market trading is constrained by the fact that the vast bulk of G-Secs are maintained in the held to maturity (HTM) buckets of public sector banks; given the profitability and balance sheet concerns in many of these banks, RBI has been unable to compel a smaller share of HTM, which would drive more trading and liquidity, which is necessary to completely close out the small, but still sustained arbitrage between domestic borrowings and FX borrowings. Clearly, this change will take time as the efforts to clean up the banking sector unfold. [Incidentally, the idea of permitting corporate groups to float banks as part of this effort is, in my view (which is shared by many others), dangerous and not recommended at all]. Credit to Governor Das so far—keep it slow and steady.

The author is CEO, Mecklai Financial. Views are personal