Why Local Rupee Traders Must Continue To Watch The NDF Market

Offshore non-deliverable forward markets for the rupee can influence the onshore forex market, more so in times of short-term volatility, a working paper by the Reserve Bank of India found.

This market, heavily used by foreign investors, has become a thorn in the side of regulators, who find it difficult to control activity in that segment unlike in the local market.

The findings of the working paper titled, "Does offshore NDF market influence onshore forex market?” suggest a stable long-run relationship between onshore and non-deliverable forward markets.

The short-term spillover is found to move in both directions across onshore and offshore markets. However, a sub-sample of data between November 2014 and December 2019, found that cues move one-way, from offshore to onshore markets.

The sub-sample analysis also shows that volatility spillovers not only become unidirectional, but also increase significantly during the periods of heightened uncertainty.

"In view of the growing size of the NDF market, these findings are cause of concern for policymaking, as any disruption in offshore market is beyond the domestic policy purview and can make domestic markets volatile", the paper, authored by Harendra Behera Rajiv Ranjan and Sajjid Chinoy, found.

Rising interest in emerging market currencies, juxtaposed with capital controls and underdeveloped onshore financial markets, has led to a parallel market for emerging market currencies, including the rupee, in offshore centres known as the NDF markets.

In the NDF markets, trading is settled in a convertible currency, usually in U.S. dollars, as non-convertible currencies are restricted to be delivered offshore. According to the last triennial survey of the BIS in 2019, turnover in offshore markets for the Indian rupee outpaced that of the onshore market.

The concern over the growing influence of offshore markets is not new.

Previously, a committee appointed by the RBI, in its report, said the sharp growth in offshore trading volumes in the rupee non-deliverable forwards markets raises concerns around the forces that are determining the value of the rupee. This increase in offshore markets can also hamper the ability of authorities to ensure currency stability.

The committee's report had attributed the rising prominence of NDF markets to restrictions on foreign exchange transactions, cumbersome documentation and KYC requirements, restrictions on market participants in hedging activities, cancellation and re-booking of contracts, permission to participate in various existing derivatives product offered by the market regulators, and inconvenient market hours for those in other time zones.

The latest study also highlights that volatility in the NDF markets is sizeable compared to onshore markets and the divergence between the two gets accentuated in times of heightened uncertainty. This is because players in the offshore market do not have access to enough information and therefore, they react more quickly. Moreover, the volatility in the onshore segments is contained by central bank intervention.

A rise in volatility in offshore market, however, is ultimately transmitted to onshore forex markets once the domestic market players start reacting to the movements in the NDF segment. A closer examination of the data on the volatilities in the two markets shows that volatility increases in offshore market before it rises in onshore markets with a lag of one-two days. Consequently, volatility spillover increases from offshore to onshore markets, during the stress period.

Recent policy measures undertaken by the RBI are likely to help in reducing rupee turnover in offshore centres and improve efficiency of price discovery, according to the paper. Some of these measures include the extension of trading hours, introduction of rupee derivatives at International Financial Services Centres and permitting Indian banks to participate in the NDF market.