Indian five hundred rupee banknotes are arranged for a photograph in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

Tackling The Growing Influence Of The Offshore Rupee Market

BloombergQuintOpinion

The Reserve Bank of India has constituted a task force to study the offshore rupee market, which, in the past, has proved to be troublesome for the currency markets in India. The country has gone through bouts of excessive speculation in the offshore non deliverable forwards market, which in turn has impacted the spot markets. These episodes have led the central bank to believe that it needs to move a larger part of the currency market back onshore.

The very fact that the central bank has acknowledged the existence of an offshore market and its impact on domestic markets is a paradigm shift. Apart from the announcement of a committee headed by former RBI deputy governor Usha Thorat, the regulator has recently taken other steps with the same intent.

These include: draft derivative guidelines, the issue of rupee denominated bonds in international markets and rules for non-residents to participate in the Indian interest rate derivatives market.

Growing Offshore Market

Generally, the development of the offshore markets emerges from the existence of capital controls on a currency, along with the size and popularity of the same for trade and capital transactions.

The offshore market provides significant benefits in the form of enabling global financial market participants to manage risk across geographies and reducing various complexities such as legal, taxation and documentary requirements stemming from dealing in onshore markets.

India is no exception to this phenomenon.

Given India’s economic potential, the large investment opportunities available and macroeconomic linkages in global economy, myriads of foreign entities have direct and indirect exposure to Indian trade, assets and investments. These overseas entities access offshore markets for hedging their currency risk, leading to the development of a robust rupee NDF market in locations such as Singapore, London and New York. NDF markets almost always net settle in dollar terms.

Data published by the Bank of England’s semi-annual survey of foreign exchange volumes show that average daily Rupee NDF trading volumes in London have gone up sharply from ~$7.9 billion in October 2016 to $23 billion in October 2018. A similar survey conducted by the Federal Reserve shows that daily average NDF volumes for Rupee traded in New York have gone up from $2.8 billion to $4.5 billion over the same period.

The principal reasons why entities would participate in offshore markets are the availability of a wider product suite, ability to execute cost reduction strategies, access to a 24-hour market, less rigorous documentation, a lower capital charge resulting in lower transaction costs and most importantly the ability to freely cancel and re-book their hedges.

The dollar-rupee NDF markets would also allow offshore corporates or hedge funds to take speculative positions apart from standard hedging activities. In addition, it provides a channel for arbitrageurs who have access to both markets to exploit the price differentials. These arbitragers are the key participants who connect the pricing of the onshore and the offshore markets for the rupee.

RBI’s Attempt To Correct The Balance

The RBI has taken all these factors into cognizance and has already proposed a number of steps.

Liberalisation of The Derivative Product Regime

The RBI intends to significantly liberalise regulations for derivative products as per the draft circular released on 15th February 2019. This draft guideline condenses earlier guidelines of over 50 pages to a few pages and is truly in the spirit of moving from rule-based prescriptive regulation to principle-based regulation. It does away with restrictions on derivative products that are allowed for both overseas and domestic entities, dispensations have been given to authorised dealer banks to decide on form and content of underlying documents.

This circular will allow gains on booked contracts for hedging anticipated exposure to be passed on at the time of realization of cash flows from contracted exposure. This can become a restriction for global players to participate in onshore markets, as it may also not meet standard trade practice requirement of global financial centres.

This needs some refinement in terms of allowing non-resident entities to freely cancel and re-book contracts wherein gains/losses on the booked contract can be settled by non-resident entity. This amount may be capped depending on the investment track record, size of fund, track record of import/export etc.

Foreign Participation In Onshore Interest Rate Swaps

Simultaneously guidelines have been issued allowing foreign entities to deal in onshore markets in rupee interest rate swaps, which has taken off within two days of issuance of guidelines.

Issue of Rupee Denominated Bonds

The RBI has also opened the door for issue of rupee denominated bonds and we have seen such issues on and off. To develop this market further, prudential norms of RBI needs clarification to allow overseas branches of Indian banks to hold bonds rated by international agencies and not only rating agencies registered with SEBI.

What More Needs To Be Done?

While we keep moving in this direction, there are a few key aspects to be borne in mind by the regulator to make a serious dent in the offshore market.

Liberalise the issue of posting of collateral by foreign investors

With regards to posting of collateral by foreign investors to Indian banks there are several restrictions prohibiting the same. SEBI regulation require securities / cash balances held by FPIs to be encumbrance free and other RBI, FEMA guidelines allow posting of margins by FPIs only on the stock exchanges. Amendments will be required in the relevant SEBI and RBI circulars for enabling non-resident entities to post collateral in the form of securities / cash deposits with Indian banks to avail credit lines for the purpose of hedging.

Create a level playing field

A level playing field needs to be created by allowing Indian banks to deal in the NDF market. This will allow domestic banks to offer both onshore and offshore products to their clients. There is a need for this as foreign banks have access to both markets and are able to provide products to Indian entities with onshore products and to global MNCs and fund houses with NDF products in Singapore, London and New York. Even though Indian banks have branches in these locations, they are not allowed to provide NDF products to global clients. This process of integration of onshore and offshore markets will also give RBI more leeway to manage currency volatility in the context of maintaining financial stability and thereby reducing adverse spill over effects to the real economy.

Trade Invoicing In Rupee

The RBI and the government will also need to promote the usage of rupee for cross border trade invoicing. In this regard, global multinational firms and fund houses should be permitted to open and operate rupee account in India and abroad for liquidity management. This will also require the facility of global clearing in rupees.

Trade Timings

Finally, a simple step aimed at better integration into the global financial system could be to extend market hours for exchanges and the over-the-counter inter-bank segment. This will allow non-resident participants to react to market-moving news after Indian markets close. The rules for non-residents to access the forex and derivatives market could also be tweaked to increase the number of participants rather than just spread existing volumes over a longer period of time.

In summary, the path adopted by RBI, allowing more foreign participation in Indian derivatives and assets, easing the hedging framework for residents and non-residents and a concerted effort to reduce funding costs for all entities by lowering hedging costs are the first steps towards reducing the influence of the offshore rupee markets. Eventually, this will make India a more attractive investment destination and Mumbai a more powerful financial centre.

B Prasanna is Group Head, Global Markets – Sales, Trading and Research at ICICI Bank.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.