A real-time monitoring of the foreign exchange (forex) markets is needed to contain any substantial spillover from the offshore to onshore markets, as per the recommendation of a Reserve Bank of India (RBI) Working Paper.

Regarding “volatility spillover”, the Working Paper “Does Offshore NDF Market Influence Onshore Forex Market? Evidence from India” observed that the spillover between onshore and offshore forex markets is bidirectional during normal periods, but turns unidirectional from offshore to onshore during episodes of intensified global risks. Moreover, the magnitude of volatility spillovers from offshore to onshore markets also rises during periods of stress.

The empirical results in the Paper, put together by Harendra Behera, Director, and Rajiv Ranjan, Officer-in-Charge, Monetary Policy Department, RBI, and Sajjid Chinoy, Chief India Economist, J.P. Morgan, suggest a stable long-run relationship between onshore and NDF (Non-Deliverable Forward) markets with price discovery taking place in spot and forward markets.

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The sub-period analysis finds short-term mean spillover effects from NDF markets to onshore spot, forward and futures markets during the stress period. “When the offshore market volume is significant or larger than that of the onshore market, price discovery can get fragmented wherein domestic market price discovery becomes vulnerable to influences from price discovery in the offshore market.”

“The presence of a large offshore market, therefore, sometimes dilutes the effectiveness of exchange rate management by a central bank and/or hinders the pursuit of domestic financial stability objectives,” the authors said.

As compared to the onshore market, the turnover in offshore rupee markets has more than tripled between 2016 and 2019, according to the paper.

In fact, the average daily NDF market turnover in the case of Indian Rupee (INR) at $50 billon, exceeded the combined over-the-counter (OTC) and exchange traded forex turnover of $48.8 billion in April 2019.

The share of the Indian rupee in the global NDF turnover has also increased significantly from 12.6 per cent in 2016 to 19.4 per cent in 2019 whereas the growth in turnover during this period was more than 200 per cent.

The Paper said there is always some gap between the exchange rates of the Indian rupee in onshore and offshore markets, due to capital account restrictions, transaction costs and basis risk. “Large spread between onshore and offshore market encourages market players to take arbitrage advantage while speculative activity in the market result in wide divergences. The large spread between INR NDF rate and INR futures/forward rate can influence the spot rates significantly,” the authors said.

Policy measures

The authors observed that the policy measures undertaken by RBI recently are likely to help in reducing rupee turnover in offshore centres and improve efficiency of price discovery.

Some of these measures, including the extension of trading hours, introduction of rupee derivatives at International Financial Services Centres (IFSC) and permitting Indian banks to participate in NDF market, are likely to improve the access for overseas participants and curb turnover in offshore centres.

Domestic banks participation in NDF segment would also support central bank at a time if it wants to intervene in offshore segment. The rise of NDF turnover in IFSC is expected to reduce the spread and thereby enhance the overall efficiency of the market.

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