In the latest Budget, the Government has proposed participation of foreign institutional investors (FIIs) in currency derivatives markets. This has given rise to apprehensions with regard to a possible speculative attack on the Indian currency.
The Indian currency derivatives market has been in operation for less than five years. FIIs, with their deep pockets, can sway the relatively small currency derivatives markets such as India, to serve their business interests.
The Budget proposal makes the Indian currency market vulnerable to expectations of FIIs, known for their short-term investment perspectives. This may have serious implications for international trade, investments and other capital flows.
NO LIQUIDITY BENEFIT
At present, there are only four exchange-traded currency futures in India, namely, USD/INR, Euro/INR, Pound/INR and Yen/INR. The USD/INR trade accounts for almost 88 per cent of currency futures trading. This reflects the skewed nature of the Indian market. It is being argued by some that participation by FIIs will provide greater liquidity to the currency derivatives market and offer an opportunity to FIIs for hedging their exposures in the capital market. This argument does not hold ground.
FII activity is likely to render currency markets more volatile, as a small number of large players will dominate the market. This may drive away small players such as exporters, importers and SMEs due to their limited risk-taking capacity and hedging skills. As a consequence, there may be a net reduction, rather than increase, in liquidity.
The argument of offering an opportunity to FIIs for hedging their exposures in the capital market is also flawed. FIIs take exposures in several global capital markets to reap the benefits of diversification and thus hold fairly diversified currency exposures, which automatically results in currency risk hedging.
Further, since their positions in currency derivatives shall be determined by their net exposures in the capital market, they may lever their exposure in equity and debt for taking larger positions in the forex market. Owing to their short-term speculative motives, they may withdraw simultaneously from both the capital and currency markets, plunging a greater part of the financial system into distress.
PAST EXPERIENCE
Apprehensions on the adverse impact of FIIs participation in the Indian currency derivative market are not unfounded, if we consider the past experience of small currency markets, in particular, and currency markets in general.
They have been able to significantly influence the direction of the market and, on occasions, have created havoc, triggering an economic crisis. A prime example is the 1992 Black Wednesday, when the UK had to devalue its currency due to a major speculative attack by Hungarian investor George Soros, who later became a nightmare for the Asian countries in 1997.
The Asian crisis was a great lesson for the countries in the Association of South-East Asian Nations (ASEAN) and the South Asian Association for Regional Cooperation (SAARC) regions to take prudent policy measures in order to thwart such a crisis in future.
Empirical evidence also supports the contention that financial markets which are heavily dependent upon FIIs are more vulnerable to contagion effects, especially during a period of economic and financial crisis.
The myth that FIIs drive market efficiency has also been exploded in the recent empirical work. It has been observed that FII investments do not drive markets, but actually speculatively chase markets which are providing high returns.
IMPACT ON INDIA
The recent policy decision can destabilise the Indian economy in many possible ways:
There may be rampant practices of possible cartelisation and herd behaviour in the currency market, leading to market imperfections. FIIs are already known for their herd behaviour in stock markets.
Based on conventional economic theory, it may be argued that if there is a high exposure of FIIs in the currency market, it may appreciate the domestic currency. This will have a distorting effect on exports and the country’s trade balance.
FIIs generally consist of a large number of loosely regulated institutions, which can breach regulatory norms at any time. A prime example is hedge funds. If these funds are allowed to take equity-based exposures in the currency market, this will certainly make currency derivatives market more volatile and risky for domestic investors.
Like stock exchanges, currency exchanges will again become an investment haven for large players.
This may marginalise the role of small investors. At present, about 40 large investors, including FIIs and big banks, account for more than 90 per cent of the trading volumes on Indian bourses, leaving little on the table for the small investors.
FII already have an option of trading in USD/INR futures contracts at several international trading platforms located in low-interest rate and low-transaction cost regimes such as CME, Inter-Continental Exchange, Dubai Gold and Commodities Exchange (DGCX), etc. Opening up of the Indian market to FIIs will place small Indian players such as SMEs, which operate in high borrowing and trading costs, at a disadvantage against FIIs.
FIIs will indulge more in arbitrage than hedging activity by taking inter-market positions, to reap extra-normal profits.
Where the hedging needs of FIIs are long-term in nature, OTC forward and swap contracts would be more suitable, owing to the flexibility in expiration dates as well as contract values.
EXCHANGE RATE RISK
The floating exchange rate system was adopted by most countries, including India. Despite its merits, it exposes economies to exchange rate variability. Market interventions of central banks such as the Reserve Bank (RBI) are extremely important in imparting exchange rate stability.
Large FII activity may enhance exchange rate volatility to levels well beyond the control of the RBI. The experience of other large emerging markets such as Brazil provides important lessons. Brazil’s currency derivatives market is 12 times its international trade. In comparison, Indian currency derivatives market is 3.4 times the level of foreign trade.
Despite the size and growth of the Brazilian market, there has been adverse impact of FII participation.
As a consequence, the Central Bank of Brazil was forced to direct its commercial banks to make non-interest bearing deposits with the central bank — at 60 per cent of short dollar positions, either exceeding $1 billion or their capital base, whichever was smaller.
In view of the Brazilian experience and the empirically documented vulnerability of Indian stock market to FII participation, it would not be desirable to allow FIIs in the Indian exchange-traded currency derivative markets.
MARKET DEVELOPMENT
Instead, the government should focus on market development measures, such as encouraging wider participation by banks, allowing new derivative instruments, setting a large lot size for institutional investors, etc.
Further, the trading hours for currency trading in India should be extended so that trade migration does not take place to competing platforms such as DGCX, which operates close to midnight hours, causing loss of revenue and taxes. It has resulted in shifting the price discovery of USD/INR contracts to international exchanges such as DGCX, reducing the Indian platforms to satellite markets.
Clearly, the proposal to allow FII participation in the currency derivative market is likely to increase exchange rate volatility, with destabilising effects for the economy and the financial system.
The government should desist from taking such a step till the market development process is complete and full-capital account convertibility is achieved.
(The authors are Professors, Department of Financial Studies, University of Delhi.)