Harun R Khan: Foreign exchange market and cross-border transactions
- some random reflections
Inaugural address by Mr Harun R Khan, Deputy Governor of the Reserve Bank of India, at
the 11th Annual Conference of the Foreign Exchange Dealers Association of India (FEDAI),
Hong Kong, 11 June 2016.
* * *
The speaker acknowledges the contributions of Shri Himansu Mohanty of the Reserve Bank of India.
1. Shri C. Venkat Nageshwar, Chairman, Foreign Exchange Dealers Association of
India (FEDAI), Shri Ravi Sinha, Acting Consul General of India in Hong Kong,
Shri D. G. Patwardhan, outgoing CEO of FEDAI, Shri Ashwani Sindhwani, incoming CEO of
FEDAI, distinguished speakers and panellists and delegates to the Conference. It is a great
pleasure to be here today in this modern city of Hong Kong which Wikipedia describes as
world's most competitive economy, the world's most visited city, and among the world's most
significant financial centres with a very high financial development index. My sincere thanks
to the FEDAI for inviting me to inaugurate their 11th Annual Convention. These Annual
events of FEDAI have been quite well known in recent times for the wide participation of the
foreign exchange market participants, for the depth and detail of the deliberations, and of
course, for the idyllic locations chosen. I am sure that this Convention too would excel its
predecessors in all aspects.
2. FEDAI was formed in 1958, when Foreign Exchange Regulation Act, 1947 was in
force and life was rather simple. The Bretton-Woods arrangement was in force, there was a
fixed exchange rate regime with Rupee pegged to the pound sterling and tranquillity reigned
in the markets, such as there were. Mandate of FEDAI was simple too: setting the basic rules
for inter-bank and customer transactions pertaining to computation of rates and settlements.
Forex market and FEDAI have traversed a long way since then in keeping with the
momentous changes that have taken place in financial markets in general and forex market
in particular, globally as well as in India. Though not formally designated as a Self-Regulatory
Organisation (SRO), it has effectively played such a role and the smooth transition and
transformation experienced by the Indian foreign exchange market over the years can be
ascribed to FEDAI in no small measure. I am sure FEDAI will continue to play such a role in
future with greater élan.
3. In modern times, the economic and market conditions have been evolving rapidly
and whenever we find ourselves in the cusp of transformational events, there is a global
dimension involved. Today, the Indian economy is reported to be more integrated with the
rest of the world than US and China in the sense that trade-GDP ratio for India (at 49.6 per
cent) is higher than that for China (41.2 per cent) and US (30 per cent). If we also look at a
wider parameter of Global Connectedness Index developed by Pankaj Ghemawat and
Steven A. Altman, India's score and rank is pretty high, e.g., in 2013 our rank at 71 was
ahead of China at 84 in a universe of 140 countries. The quest for mobilising resources for
India's vast investment needs also has a pronounced outward-looking refrain. As we engage
more and more with the rest of the world, the cross border transactions not only increase in
magnitude but also become more complex. Even as we grapple with issues, such as, how to
improve the ease of doing business to attract foreign investment and how to contain the
potential instability due to increased cross border engagements, the critical factor that
influences our thinking and policy setting is the conditions in the foreign exchange market. In
this backdrop, I shall discuss today a few select themes relating to "foreign exchange market
and cross border transactions," keeping in view the broad topics of this conference, allowing
freedom in foreign exchange markets and internationalization of Indian Rupee.
Foreign exchange market: freedom with stability
4. The modern foreign exchange market as we know it evolved after the Bretton
Woods system broke down in early 1970's and the global currencies became freely floating.
It may be recalled that in the Bretton Woods regime the currencies were almost fixed
vis-avis US dollar and the exchange rate carried within a narrow band. US dollar in turn was
linked to gold with a guarantee of the US monetary authorities. When the US Government
withdrew this guarantee on August 15, 1971 the currency market went into turmoil and a
floating rate regime came into existence. Floating rate regimes were experienced earlier for
example, during the 30's when the markets were volatile and disorderly in the extreme and
were shut down for extended periods. It may be of some passing interest to note that
Reserve Bank of India Act,1934 was framed during this period and the preamble said "
....And whereas in the present disorganisation of the monetary systems of the world it is not
possible to determine what will be suitable as a permanent basis for the Indian monetary
system...."
5. The floating exchange rate regime that came into existence in early 70's has
remained in force for four and half decades. It is not that there has not been occasions of
disorderliness and turbulence in the market but the regime has not been over turned.
6. Three interrelated factors have contributed to the evolution of foreign exchange
market as we see it now. First, there has been tremendous improvement in global
communication infrastructure gone are the days when trading and settlement used to be
done over telegraphic systems (hence the term cable rate). The modern communication
network has reached the time and space gap and the only limitation now is the diurnal
motion of the earth. Secondly, this period also coincided with quantum advancement in
computing capacity. This has helped in improving the communication network. But more
importantly it has made trading and settlement quite easier. It is possible for the trader as
well as the back office to instantaneously understand the implication of a trade. The ultimate
culmination of this is of course "algorithm trading". Thirdly, along with the development in
computation, sophisticated mathematical models have evolved to engineer complex and
bespoke financial products. A combination of these three factors has brought about a foreign
exchange market that is truly global, liquid and large.
7. Notwithstanding the complexity and sophistication of the foreign exchange market,
the fundamental principle remains simple yet profound. The foreign exchange market deals
with currencies and a foreign currency is but a commodity vis-a-vis the domestic currency.
The price is the exchange rate. Any price has two determinants. The supply factor and the
demand factor. The first can be seen to be derived from the cost of production and the
second from the factors that affect demand, utility for instance. In the foreign exchange
market, the first factor which ultimately determines the exchange rate in the long run is the
purchasing power parity or the inflation differential. The second factor that causes exchange
rate movement in the short run is the expected earnings from exchange rate dynamics. In the
simplest of cases it is derived from interest rate differential but in the real world the exchange
rate demonstrates random walk and behaves like any other financial asset. It will be
important here to remember that both the factors play equally important role in determination
of the price. To quote Alfred Marshall, "We might as reasonably dispute whether it is the
upper or the lower blade of a pair of scissors that cuts a piece of paper, as whether value is
governed by utility or cost of production. It is true that when one blade is held still, and the
cutting is effected by moving the other, we may say with careless brevity that the cutting is
done by the second; but the statement is not strictly accurate, and is to be excused only so
long as it claims to be merely a popular and not a strictly scientific account of what happens
(Marshall [1890] 1997, 290)."
8. The exchange rate is a key macro-economic variable. It shapes a country's balance
of payments and engagement with the rest of the world. It affects a country's export
competiveness, of course in conjunction with other factors and its income and employment to
the extent that export sector is important for the economy. It determines the cost of import
and to the extent that import constitutes articles essential for investment and growth, can act
as a retarding factor. It affects the price level through the linkages provided by the tradeable
sector.
9. As we have seen earlier foreign currency behaves like a financial asset. The prices
of all financial assets are forward looking and are based on the expectation of the future state
of the world. As such a country can face large capital inflows or outflows depending on
whether its future is perceived to be promising or discouraging. This in turn can affect the
exchange rate which may not be in consonance with the fundamentals of the real economy
for example the appreciation of the Rupee in 2007-08 was caused by large capital inflows
attracted by a buoyant and promising economy but affected the export sector adversely. The
reverse was perhaps the case in the East Asian crisis. The capital flows also pose challenge
for the monetary policy setting. I allude to the much discussed Mundell-Fleming trilemma,
i.e., it is impossible to have an open capital account independent monetary policy and fixed
exchange rate. Capital account openness and independent monetary policy framework could
lead to flexible exchange rate which can be disorderly and volatile.
10. The reason I am discussing these issues in some detail is to emphasise the
criticality of the exchange rate. The importance of exchange rate cannot be over emphasised
for developing countries. For instance, it has got special importance for India like
unemployment for Americans and inflation for Germans. The memory of the 60's and 70's
when the critical shortage of foreign exchange reserves forced us to resort to the PL 480 for
meeting the food requirement of the country are pretty strong. Exchange rate movement
either way can affect us adversely. Appreciation could hurt our exports and depreciation
would make the imports expensive. Given that our large part of imports comprises crude,
fertilizer, capital goods and intermediates, increase in the cost of imports due to depreciation
of currency can hurt our growth and employment and affect the fiscal balance.
11. In this backdrop, there are two questions that need to be posed. First, how to ensure
that the exchange rate remains stable and, as is stated in the preamble to FEMA, 1999, how
to preserve orderliness in the foreign exchange market? Second, the exchange rate will be
stable and not fixed, and therefore, there will be some volatility in the foreign exchange
market. Therefore, how to enable those affected by the exchange rate to cope with the risk
inherent in a volatile market?
12. I will deal with the second problem first. As long as the inflation differential between
India and the other countries remain positive, the Indian currency will exhibit depreciation
over the long term. However, in a world dominated by capital flows, there can be significant
deviations from the long-term path indicated by the Real Effective Exchange Rate (REER).
REER itself, one should note, is a function of several dynamic factors and variables and
hence, may not serve as very accurate anchor as the base period loses its relevance in the
face of more recent developments. Even in the case of US dollar, the deviation from the long
term represented by the REER is known to have been of the order of 80 per cent. Such
volatility affects the earnings and balance sheet of all firms that have contracted or even
economic exposures. The approach to resolve this problem is to provide a deep and liquid
foreign exchange derivatives market to enable market participants to hedge their foreign
exchange risk. I have spoken about the derivatives market in detail elsewhere and do not
wish to deal with it in detail here.1 The most straightforward derivatives are the forward
contracts or their exchange traded counterpart, the currency futures where the payoffs are
simple and linear. While the pricing of these derivatives are fairly simple based on the
interest rate differentials, the use of these products by the market participants is mostly
motivated by their expectations of the future spot rate. Ordinarily, if you have a foreign
exchange receivable or payable and if you have entered into a forward sale or buy contract,
your exposure is evened out and you should not be bothered about what happens to the
exchange rate. However, the concept of mark-to-market is not only in the books of accounts
but also in the people's minds. Not unexpectedly, a cloth manufacturer and exporter decides
her hedging strategy based on her own view of the expected future spot price as different
from the forward price and of course often based on advice of "experts". As I have mentioned
earlier, the foreign exchange rate exhibits random walk in the short run and the best
prediction of tomorrow's rate is today's rate. About "expert" advices, I can only paraphrase
Samuelson's famous words, "To prove that Wall Street is an early omen of movements still to
come in GNP, commentators quote economic studies alleging that market downturns
predicted four out of the last five recessions. That is an understatement. Wall Street indexes
predicted nine out of the last five recessions! And its mistakes were beauties."2 Now, after
having booked a forward contract, one tracks the path of the spot rate and starts revelling or
repenting about the imagined gains or losses!
13. The other way of hedging risk is by using non-linear derivative options. Once
nonlinearity is brought into hedging strategy, the universe becomes virtually unlimited. Any
combination of linear derivatives will still have linear payoffs. But combination of non-linear
derivatives with themselves or with linear derivatives can result in payoffs of varying
complexity. Such complex products along with a future that is shrouded in ignorance can
have pretty unpleasant outcomes and sometimes even threaten market stability.
14. In this backdrop we have adopted a gradualist approach in respect of regulation and
expansion of forex derivatives market, keeping in view certain uncertainties we have
witnessed in the global and local level macro-economic environment. On the one hand, we
are committed to enable any entity, whether resident or non-resident, with an exposure to the
exchange rate of Rupee to hedge it using onshore derivatives and on the other, we have
been circumspect about introducing new products, such as, complex options including the
so-called exotics for reasons no other than the misuse of the products, either not matching
with one's risk or even for buying risk with a speculative strategy. As I see it, the universe of
permitted derivatives will expand and even undertaking a derivative transaction will become
simpler. All this, however, depends on how stable the currency markets remain and how
responsibly the market participants behave. I hardly need to stress that in all financial
transactions in general and derivative transactions in particular, the principle caveat venditor
applies just as strongly as the principle caveat emptor.
Regulating cross-border transactions: responsibility & responsiveness
15. Now I come to the first question I had posed earlier, that is, how to ensure stability of
the exchange rate. The obvious response that springs to one's mind is intervention by the
central bank. Intervention, however, is to be used only in extreme situations and cannot be a
part of the policy framework. Intervention has got costs and other implications like negative
carry of the foreign exchange reserves, interference with the monetary policy framework,
cost of sterilization of intervention operations, etc., depending upon whether intervention
consist of buying or selling foreign exchange. The strategy, therefore, seems to be a
combination of some capital controls and flexible exchange rate. Earlier this year, the Bank
of Japan Governor Kuroda was reported to have advised China to "impose capital controls to
defend the yuan rather than keep burning through currency reserves"3. The role of capital
controls, rather active capital account management, in preserving stability in the external
sector and foreign exchange market has now been well recognised in the aftermath of the
global financial crisis. Some studies have shown that capital controls measures for capital
account management are desirable in certain circumstances even when the exchange rate is
flexible. Here, I can cite the examples of how we have been calibrating the outflows
permitted under the Liberalized Remittance Scheme (LRS) and the inflows under the
External Commercial Borrowings (ECB) framework in the Indian context.
16. During the FERA regime, there was complete exchange control. Not only capital
account, even current account transactions were also subject to control measures. During
the acute foreign exchange crisis, the capital accounts were opened up slightly for the
expatriate non-resident Indians by way of incentivised accounts, access to the secondary
market in equities, etc. Since the liberalisation process started in the early 1990s, the capital
account has been progressively liberalised. We were courageous enough to think of full
capital account convertibility on two occasions - in 1997 and in 2007. Unfortunately, because
of unfolding of global macro-economic developments, the implementation of the path to full
capital account convertibility remained on the drawing board stage. Our commitment to
progressive liberalisation of the capital account has of course remained steadfast through the
problems ranging from the post-Pokhran II global reactions to the recent global financial
crisis.
17. What has been our approach to management of capital account? One way of
looking at the issue is to see how it affects three different segments of the economy - the
non-financial firms and businesses, the individuals and the financial firms. As far as the first
segment is concerned, a more open capital account provides better access to resources and
investible funds, brings in better technology and management practices and improves their
valuation. Right since the first days of opening up of capital account, the emphasis has been
to ensure that the real sector is not deprived of the benefits of an open capital account. We
can say that, in effect, the capital account is fully open for most of the real business sector.
The restrictions are in respect of individuals and the financial sector. In a resource starved
country, enabling individuals, particularly those with high net-worth, to transfer their wealth to
foreign places is surely a low priority policy objective. As far as the financial sector is
concerned, the restrictions stem from the premise that it is this segment which creates
systemic vulnerabilities in an open economy.
18. There is another way of classifying capital flows, viz. by the asset class - equity,
debt and immovable property. The distinction between equity and debt is too well known.
The two financial contracts have their own structures and implications. From the limited
perspective of external sector stability, suffice it to say that while a capital inflow in the nature
of equity poses little stability issues (except in socially or economically sensitive sectors
where foreign ownership may not be considered appropriate) debt contracts can lead to build
up of significant risks at the firm and more importantly at the systemic level. History stands
witness to this proposition. Whether it is Latin America or East Asian countries or Greece in
recent times, financial and economic stability were rooted in borrowing a foreign currency or
in a currency over which the country had no control.
19. The regime for foreign debt is dictated by the concern for excessive indebtedness in
foreign currency which can sow the seeds of instability. Take the example of the ECB the
regime as is in force today. The prudential focus of the current ECB framework is to provide
a nudge towards long term borrowing to mitigate rollover risk and/or borrowing in Rupees so
that currency risk is not borne by the borrowers, discouraging borrowing by those who do not
have any natural hedge by way of foreign currency earnings or earnings linked to the
exchange rate, all-in-cost-ceiling to prevent poor quality borrowers from accessing risky
foreign currency loans and encouraging borrowings from long-term lenders/investors like
sovereign wealth funds, insurance companies and pension funds.
20. Here, I would like to mention two inter-related issues in the passing. Often, we hear
mention of foreign currency borrowings as a source of cheap funds. Is it really cheap? In a
perfect market with no capital account restrictions there should not be any opportunity for
arbitrage between a fully hedged foreign currency borrowing and a Rupee borrowing on the
one hand and when the borrowing is long-term with coupons and repayments spread over
the lifetime of the borrowing and between the cost of hedging and the long term average rate
of depreciation on the other. Thus, as far as the cash flows are concerned, it would not
matter whether an Indian firm avails of foreign currency borrowing or Rupee borrowing. The
arbitrage opportunities that exist are due to market imperfections and barrier to arbitrage. But
whether foreign currency borrowing is truly cheaper requires deeper study with long-term
data. The second issue relates to whether foreign currency borrowings should be hedged? It
is intuitive to expect that those whose revenues are neither in foreign currency nor are
indexed to the exchange rate should not leave the currency mismatch unhedged. Although it
may be argued that the cost of hedging is often more than the rate of long term depreciation
of the Rupee, it is worth asking the question whether one can trust one's instinct to remain
unhedged hoping and betting that one would be able to ride on the best part of the exchange
rate cycle or protect oneself against possible adversities in line with a prudential risk
management framework. This choice has to be very carefully evaluated.
21. Coming back to the issue of other asset class of equity, it needs to be noted that the
regime for foreign investment in equity is pretty permissive - be it as foreign direct
investment or foreign portfolio investment. As far as I can see, the only two high level
restrictions: (i) in a few sectors where the extent of foreign investment is capped due to their
sensitive nature and, (ii) in the stipulation that the issue or transfer of securities should be at
fair value. But as always, the devil often is in the detail. Obviously, the investment should be
in equity securities. Some leeway is provided through hybrid securities - fully and
compulsorily convertible preference shares and debentures. The other hybrid securities such
as partially convertible debentures, optionally convertible debentures or equities with
embedded optionality are not treated at par with equities and hence not permitted as
instruments for making foreign direct investment.
22. Most of the details of the structures in the foreign direct investment regime comes
from the concern to allay the appreciation that a FDI should not be used as a camouflage for
debt. But how complex does the structure become! In a manner of speaking, every
investment is an act of speculation. Every investor must have an expectation about future
state of affairs and the cash flows or return that will accrue to him. Every act of investment is
subject to the usual information asymmetry. Therefore, every investment contract must
provide for the probable states of affairs and how the investor will protect himself against the
uncertainties and the information problems. Straitjacketing investment contracts, thus, often
results in disputes, or worse, much needed investment shying away from socially useful
sectors. Here I would like to refer to cases where hybrid instruments (e.g. optionally
convertible preference shares) are issued with the option to exit linked to pre-determined
milestones. This becomes imperative as investment strategy of many investors (e.g. Private
Equities) is often different and there is need for a reasonable exit option under certain
circumstances without any assured return.
23. This problem is aggravated by the way the FEMA is structured. Unlike in case of
current account transactions, where the principle is that everything that is not specifically
forbidden is allowed, in case of capital account transactions the principle is that only anything
that is not allowed is forbidden. This makes a great demand on the framers of regulations,
lest the investment and business is subject to the limitations of their perceptions. The way
business is done is forever evolving and it is a difficult job for the regulators to keep pace
with it. There is a very good case for relooking at this principle and align the regulatory
approaches for current and capital account transactions. Even as we liberalise capital
account more and more, the universe of restrictions shrinks and the regulatory structure will
be simpler if it mentions what is prohibited rather than what is allowed.
24. As we move to more liberalisation and rationalization of regulations, there have
been some unsettling developments in the recent past. Advance remittance for imports
without any corresponding imports into India, receipt of advances for exports without exports
materialising for a long time and more recently the revelations of the so called "Panama
Papers". In case of Panama Papers, on the basis of reports, it is suspected that some Indian
individuals may have been involved in setting up of businesses maintaining balances abroad
illegally. Investigations are on and the situation can be assessed only on conclusion of the
process when full details are available. The question that troubles us is should the unfolding
of these events influence our approach to regulating cross-border transactions?
25. On this subject I cannot help recalling what the Finance Minister Yashwant Sinha
said in the Lok Sabha on November 19, 1999 while replying to a debate on the Foreign
Exchange Management Bill. I quote "What we are trying to do through this legislation is to
bring the entire management of foreign exchange in line with the changes which have taken
place as a result of liberalization on current account. I strongly refute with all the emphasis at
my command that this piece of legislation is going to help the blackmarketeers, the black
money operators or the hawala operators. This is a figment of the imagination of a section of
the Members of this House and I refute it as I said with all the emphasis at my command.
This is in terms of meeting a new situation which has come about as a result of liberalization
of the foreign exchange management and the Act will only facilitate that management. That
is the reason why we are introducing this legislation. We have already introduced the
Prevention of Money Laundering Bill. The two legislations, I will suggest, should be
considered together because they cover the entire gamut of the issues that are involved in
these two pieces of legislation."
26. Often what comes across as contraventions of FEMA indeed are issues related to
tax evasion or money laundering. I wonder if it would not be more appropriate to deal with
these wrongs within the framework of tax and money laundering laws. It is nobody's case
that these wrong doers should go unpunished; indeed the punishment should be swift and
exemplary. What I am emphasizing is that this should not colour our perception in respect of
cross border transactions and mould our regulatory approach in a regressive fall back to the
FERA mindset. After all, countries with no foreign exchange laws do have such wrongs and
do effectively deal with them. There is a case for avoiding any possible attempts for
regression into FERA regime. This will of course be helped by Authorised Dealers in foreign
exchange collecting, collating and sharing the information so as to ensure that the regulatory
intent is not compromised in letter and spirit.
27. Just a word in passing on the internationalisation of the Rupee in recognition of the
fact that this is one of the themes of this Conference today. This has been an exciting topic of
discussion amongst the academia and market participants in recent times. In the annual
conference of FEDAI held in Zurich in
20124, I had alluded to this aspect in some detail
keeping in view the seven prerequisites for moving towards internationalization of a currency
as laid down by Peter Kennen. The issues relating to pace and sequence of
internationalization; in fact, even its definition and desirability, continue to be raised with a lot
of passion. I must mention that the Rupee was in a sense an international currency till the
60's and it was even a legal tender in parts of Africa and much of Gulf. Those were the
Bretton Woods days of fixed exchange rate and the Rupee was linked to the Sterling. After a
quarter century of near autarchy in currency, the 90's saw a flexible exchange rate regime,
complete convertibility on the current account and gradual opening up of the capital account.
Today, Indian holding of global assets including the official reserves and the global holding of
Indian assets are very large. India has tremendous growth prospects and even in these days
of tardy growth around the globe, the Indian growth story continues to be a beacon of light.
The world obviously wants to have a share of this pie and Indian assets continue to be
valued and attractive. But with this will come the exposure to the volatility of Indian Rupee
and the need for hedging the risk. The NDF market came into existence to address this need
and, no wonder, continues to thrive. The correct approach to address this problem is not to
engage in an ad hominem tirade against the NDF market and its participants but to address
the genuine need by increasing the access to domestic onshore market to all those who
have a legitimate Rupee exposure. Several steps have been taken in this direction and more
are in the offing.
28. In a sense, internationalisation of Rupee is rather a process than an event. The
pace of the process depends upon how fast the capital account opens up which in turn
depends upon the evolving macroeconomic conditions and the financial stability concerns.
Rupee cannot be an international currency by issue of a fiat. Pound Sterling in its time or US
Dollar today achieved the status of the leading international currency of the day because the
inherent strength of their economies and their financial markets and not by any administrative
proclamation. The conditions necessary for greater internationalization of Indian Rupee in
terms of its acceptability in trade and other cross-border transactions, as a reserve currency
and reaching much higher level of capital account convertibility will be ensuring the
macroeconomic stability, and having a deep and liquid financial market. In the interim, the
measures taken and planned for using Indian Rupee in trade denomination and settlement,
particularly with our neighbouring countries, where intra-regional trade volumes are very low,
should be taken forward. And also the facilities for onshore hedging of all non-resident
entities for their increasing capital account exposure including off-shore Rupee bonds issued
by multilateral institutions and Indian corporates should be eased further.
Concluding thoughts
29. As I prepare to hang my boots after a long campaign, various shades of feelings and
emotions flash across my mind. I have had an almost four decade long association with the
country's central bank and with its financial system. This is a pretty long period in the modern
times. Around the time I joined the Reserve Bank, momentous things were happening
around the globe. The Bretton Woods System had broken down, so had the Smithsonian
Agreement. Following the Jamaica Agreement of Jan 1976, the flexible exchange rate
regime had been officially endorsed. The European Exchange Rate Mechanism was being
conceived and would be introduced in 1979, to culminate in a single currency two decades
later.
30. Closer home, though the "draconian" legislations FERA, enacted in 1973 and
COFEPOSA, in 1974 were at their prohibitive peak, w