H R Khan: Musings on the FEDAI, the forex market and the Indian rupee
Keynote address by Shri H R Khan, Deputy Governor of the Reserve Bank of India, at the
7th Annual Conference of the Foreign Exchange Dealers Association of India (FEDAI),
Zurich, 5 April 2012.
* * *
The speaker acknowledges the valuable contributions of Shri. G Padmanabhan, Shri. G Mahalingam, Shri.
Chinmoy Kumar, Shri. Rakesh Tripathy, Shri S. C. Rath and Shri. Surajit Bose.
Dr. T V Nagendra Prasad, Charge d'Affairs, Embassy of India, Mr. Phillipe Welti, former
Ambassador of Switzerland to India & Bhutan, Mr. Beat Siegenthaler, Executive Director,
UBS, Ms. Varsha Vasant Purandare, Chairperson, Foreign Exchange Dealers Association of
India (FEDAI), Mr. D. G. Patwardhan, Chief Executive Officer, FEDAI, Mr. N. S. Venkatesh,
Chairman, The Fixed Income Money Market and Derivatives Association of India (FIMMDA),
Mr. C.E.S Azariah, Chief Executive Officer, FIMMDA, Mr. G Mahalingam, Chief General
Manager, Reserve Bank of India, and distinguished delegates to the 7th Annual Conference
2012 of FEDAI.
It is a pleasure to be with you in this beautiful city of Zurich and discuss some of the
contemporary issues which are likely to pave way for the new order that is being ushered in
for creating a more robust, more transparent and less risky financial sector. As you would be
aware, a host of committees under the aegis of the Bank for International Settlements (BIS),
which is headquartered close to Zurich in Basle, are rewriting rules governing the banking
and market practices and India is a part of most of these committees. The regulatory regime
of the international financial architecture is undergoing a metamorphosis post recent global
financial crisis. In this scenario, it is perhaps appropriate that a forum like this reviews the
relevance of the existing order, with particular reference to our foreign exchange market, in
the light of fast changing developments around us.
I shall start my address by revisiting the role of the FEDAI. I shall focus more generally what
should be the role of a Self-Regulatory Organization (SRO) in today's context and particularly
what should be the role of FEDAI in the changed environment of our forex market. Moving
over to some of the core issues relating to the forex market in India, I will briefly touch upon
some of the recent measures taken by the Reserve Bank. Finally, I will briefly discuss the
issue of internationalization of Indian Rupee, a subject which is assuming critical importance
in the context of search for alternative reserve currencies and the role for currencies of major
Emerging Market Economies (EMEs) like China and India.
Evolution of FEDAI in the changing environment of Indian forex market
As you may be aware, in the early post-Independence years, under the Foreign Exchange
Regulation Act (FERA), 1947, a few foreign banks, designated as Exchange Banks were
permitted to transact foreign exchange business. The terms and conditions for undertaking
such business were being laid down by the then Exchange Banks' Association. With the
increase in India's foreign trade, several scheduled commercial banks were authorized by
the Reserve Bank to deal in foreign exchange business. This led to the formation of FEDAI
on August 16, 1958 with a mandate to lay down the terms and conditions which were
mandatory in nature for the Authorized Dealers (ADs). With developments in the Indian
foreign exchange market and growth in external trade, the role and responsibility of FEDAI
underwent changes. I am happy to note that FEDAI, through its members, continues to play
a pivotal role in dissemination of the foreign exchange related banking expertise across the
country which has led to significant improvement in the customer service.
Let me now highlight two important milestones in the evolution of Indian forex market. In the
year 1994, an Expert Group on Foreign Exchange Market in India was set up under the
Chairmanship of Shri. O. P. Sodhani, the then Executive Director, Reserve Bank of India
(popularly known as the Sodhani Committee). The Committee had made wide ranging
recommendations ranging from methodology for correct computation of Open Exchange
Position to introduction of Rupee based options and these suggestions had laid the
foundation for a modern foreign exchange market in India. FEDAI played an important role in
supporting the Reserve Bank in implementing these pioneering measures and suggestions
aimed at major reforms in the market. The second milestone was the replacement of
restrictive FERA with the Foreign Exchange Management Act (FEMA) in the year 2000. This
provided further fillip to the development of the foreign exchange market which can be
gauged from the rise in the average daily forex market turnover from approximately
US$ 6 billion in 2000 to nearly US$ 60 billion in 2010-11. This figure excludes the daily
turnover in the exchange traded currency futures market which would add up to another
US$ 5 to 7 billion a day. The depth of the foreign exchange market can also be gauged from
the fact that the bid offer spread in USD INR pair is now around half a paisa. The average
daily foreign exchange turnover has, however, showed a dip since the second half of
December 2011. One plausible reason for the decline could be the administrative measures
taken by the Reserve Bank of India to moderate the excessive volatile conditions prevalent in
the foreign exchange market but I will touch upon this issue a bit later in my address.
Future role and responsibilities of FEDAI
Having briefly touched upon the significant role played by the FEDAI so far, let me now turn
to the possible future role and responsibilities of the FEDAI with special focus on should
FEDAI become a full-fledged SRO.
Many countries rely on self-regulation because expansive resources are required to regulate
the financial markets effectively, especially in large and complex markets. With the existence
of an effective SRO, often referred to as frontline regulator, the statutory regulator (the
Regulator) relies on the SRO to carry out supervision of operations and activities of the
market participants. The supporters of the idea of self-regulation claim that it offers significant
advantage over direct government/statutory regulation. This can be attributed to the fact that
SROs have thorough domain knowledge of their respective area and regulatory framework
within which they operate. Therefore, they are considerably more flexible, context-driven and
are able to respond faster to the changes in market conditions. This also allows the
Regulator to spare its resources more on identifying and responding to major systemic risks
and to other priorities outside the ambit of self-regulation. It is believed that self-regulation
system works effectively because of the business incentive to operate in a fair, financially
sound and competitive marketplace. The critics, on the other hand, argue that private profit
seeking enterprises cannot be trusted to regulate their own activities as such self-regulation
tends to create an illusion of regulation. In addition to the conflict of interest, critics of
selfregulation point to certain other inefficiencies, such as, widespread collective action
problems, lack of effective enforcement capabilities, inability to gain or maintain legitimacy
and the failure of accountability.
Having weighed the views of the supporters and critics of the SRO system and in view of the
increasing complexities of financial markets and activities, it is important to realize and
emphasize that industry self-regulation cannot fully replace government regulation and
supervision of the financial services sector. At the same time, it may not be out of place to
say that co-operation amongst the statutory regulators and SROs in an increasingly complex
financial environment is no longer an option but a necessity. Co-ordination and
communication should be structured to address potential problems before they occur. One of
the important regulatory lessons learnt from the recent global financial crisis is the need for a
concerted response. The Government or the Regulator alone cannot provide an effective
response. Active engagement of market participants, in particular through industry
organizations, such as, SROs and other industry bodies with some self-regulatory capacity,
is essential to craft practical regulatory responses and to act effectively on policy changes.
In this era of fast paced liberalizations and developments, FEDAI should gradually assume
the role of a full-fledged SRO. Typically, a generic and effective SRO in its template of
elements cover, inter alia, internal rulemaking process, authorisation and access to
marketplace, including fitness/qualification standards for market intermediaries, surveillance of
market activities, administration of dispute resolution, sharing information and cooperating
with other SROs and the regulators, etc. SROs enable members to exercise self-discipline,
make regulations more responsive to market demand and also promote innovation and
development in a market based approach. This is critical for the development of the financial
markets in order to make them competitive, regionally and globally, and improve standards of
conduct by self-regulation.
Developmental role of FEDAI
When the Reserve Bank issues instructions, it is expected that the instructions are
understood, interpreted and implemented in a uniform and customer friendly manner by all
ADs without building up system level stresses. In the absence of unambiguous clarity of
instructions to the base level official, the objectives of various measures initiated by the
Reserve Bank may not yield the desired results. With the advent of FEMA which aims at
facilitating external trade and payments besides promoting orderly development and
maintenance of forex market in India, the economy has been witnessing rapid liberalizations.
In such a scenario, FEDAI needs to monitor the level of customer service and consumer
protection provided by its members and try to fill the gaps arising out of inadequate
knowledge or operational bottlenecks. The Reserve Bank has been emphasizing the need
for designing some basic training module covering the rules & regulations and also the
operational guidelines for the frontline staff at the branch and corporate office levels. Such a
module will help them in improving the foreign exchange related customer service, reduce
incidents of complaints and bring down the level of correspondence seeking clarifications
both within the bank and from the Reserve Bank. Member banks of FEDAI and the Reserve
Bank have since formed a Group which is working to develop an elearning module to
address these concerns. Another related area where FEDAI is expected to play an important
role is in framing of a Citizens' Charter in the area of foreign exchange business.
Role of market participants - freedom with responsibility
Let me now turn to the second part of my address, perhaps more relevant to many in the
audience in our current context.
An efficient market not only requires proper infrastructure, knowledge, skills and enabling
environment but also a great degree of market discipline reflected through responsible
behaviour by all the market participants. As was experienced during the recent global
financial crisis, among other reasons, the greed of insensitive financial engineers for short
term gains caused huge financial and economic damages to some of the most developed
nations and markets. This has, in fact, become a major focus of discussions across the
jurisdictions after the financial crisis.
In the past, it has been argued that market discipline can play a key role in incentivizing
market participants to limit their excessive risk taking activities. The events of the last few
years, however, have proved the inadequacy of market discipline. Bankers have been found
to be actively engaged in risktaking activities disguised as value-creation. Time and again
market participants have engaged in herd behaviour and put the financial system at risk, at
times by encouraging speculative build-up in the name of hedging for risk management. The
events of the past few years tell us that market discipline expressed via market prices cannot
be expected to play a major role in constraining risk taking. Therefore, the primary constraint
needs to come from regulation and supervision. Since the ADs are the major players in the
domestic foreign exchange market in India, one would expect much higher responsibility
from them. Reserve Bank has come across instances where a few banks failed to live up to
that kind of expectations and have deviated from the ethics by misselling forex derivative
products which resulted in enormous problems for the banks as also for the corporates some
of which were carried away by the greed of making money from activities other than their
core business operations.
As you may recall, the existing guidelines on OTC foreign exchange derivatives were revised
in December 2010 in the context of developments in the international and as well as the
domestic markets. The revised guidelines put more emphasis on the suitability and
appropriateness aspects of products being offered. Market-makers have been advised to
undertake derivative transactions with a sense of responsibility and cautioned to avoid,
among other things, misselling. These products are to be offered to corporates who
understand the nature of the risks inherent and have a well laid down risk management
policy. Such policy must clearly lay down, inter-alia, guidelines on risk identification,
management and control, prudent accounting and disclosure norms and must be capable of
ascertaining the mark to market positions on an on-going basis. In fact, the Reserve Bank
has made it mandatory for the market participants to offer a tool or a calculator which would
enable the corporate to mark to market these products on a continuous basis. Though the
objective of the policy is prudential in nature as it protects the market participant against the
credit, reputation and legal risks, it is important to realize that the policy protects the interest
of the corporates as well.
Let me also reiterate that banks need to closely monitor the un-hedged foreign currency
exposures of corporates as they had hedged approximately only 60 per cent and 38 per cent
of their trade and non-trade related exposures respectively till December 2011. Excessive
risk taking by corporates could lead to severe distress to them and large credit loss to the
banks in event of sharp adverse movements in currencies. In 2008, it was conveyed to the
banks that they should have a Board approved policy covering un-hedged foreign exchange
exposure of all the clients including Small and Medium Enterprises. Banks while extending
fund and non-fund based credit facilities to corporate, should rigorously evaluate the risks
arising out of un-hedged foreign currency exposure of the corporates and price them in the
credit risk premium as we have recently reiterated in our circular following the
announcements made in the Second Quarter Review of the Monetary Policy 2011-12.
During the recent episode of excessive volatility leading to sudden and sharp depreciation of
Indian Rupee against US Dollar, it was noticed that the flexibility given to banks for fixing
their intra-day limits, which were in many cases, significantly higher than their net overnight
open positions limits, were often being used for building up speculative positions and taking a
directional bet on Rupee. The facilities given to corporates by way of cancellation and
re-booking of their forward contracts and booking of forward contracts under past
performance criterion were also not being used in the right spirit. As you would appreciate
such speculative forces tend to be self-reinforcing and often result in a situation where
exporters keep on deferring their receipts and importers rush in to buy forwards, thus
aggravating the situation in hand. The administrative measures undertaken by Reserve Bank
in the month of December 2011 were aimed at curbing these speculative behaviour of such
entities. The measures did achieve the intended policy objectives and also led to an
immediate fall in the volumes of the markets. The actual hedging requirements of the real
sector, however, were not left unattended as we subsequently relaxed some of the measures
to accommodate customer needs. Within the overarching prerequisite of facilitating genuine
hedging needs of the customers, Reserve Bank would consider relaxations, in particular
those relating to intra-day position limits, in a calibrated manner at appropriate time.
Let me assure you that Reserve Bank will continue with its calibrated and gradual approach
towards liberalisation of the foreign exchange market in India but at the same time we will
expect greater degree of responsibility and accountability from all the participants. In the
context of our measured approach to market liberalisation, there has been a lot of debate on
scope of wider usage of Indian Rupee both in the region/abroad, or in other words,
internationalization of Indian Rupee. I will now briefly touch upon the issue in the third and
last part of my address.
Challenges for Internationalization of Indian Rupee
In view of the recent crisis in the financial market which resulted in a slowdown in the world
economy, some views have emerged from various quarters on whether the Indian Rupee
could play a larger role as an international currency. This issue assumed a topical and, if I
may add, patriotic significance when the symbol for Indian Rupee was unveiled amidst huge
media publicity. Proposals for use of local currencies of the EMEs under bilateral and
multilateral arrangements including the initiatives taken by China for Yuan and the recent
suggestions emanating from BRICS nations have provided renewed focus to this. It is a
known fact that wide acceptance by participants in trade and financial markets makes a
currency a popular option for trade settlement and for maintenance of reserves. The
characteristics which a currency needs to possess before it could become popular as a
transactions currency would include free convertibility, ability to invest, borrow, issue
marketable instruments, significant volumes of international trade in different regions, stability
of the exchange rate, the currency being a favoured choice for invoicing which would,
interalia depend on the mutual negotiating strength of trading partners, availability of deep foreign
exchange markets, cost-effective hedging facilities including forward cover, availability of
efficient banking arrangement/market infrastructure, etc.
Based on the analysis of Prof. Peter Kenen of Princeton University, we can lay down the
following seven broad prerequisites for the process of internationalization of a currency.
i. Domestic entities are permitted to invoice some of their exports in the country's
currency, and similarly foreign entities are also allowed to invoice their exports in
that country's currency;
ii. There should be no restrictions on any entity, domestic or foreign, to buy/sell its
country's currency in the spot and forward markets. In other words, there should be
freedom of foreign-exchange trading by domestic and foreign entities and no limits
be imposed on holding the domestic currency and derivative instruments
denominated in it;
iii. Foreign entities/financial institutions/official institutions, and individuals, are
permitted to hold the country's currency and financial instruments denominated in it
as a part of prudent investment strategy/the official reserves;
iv. Foreign entities, including official institutions, are able to issue marketable
instruments in the country's currency. These may include both equity and debt
instruments, not only in the country's domestic markets but also in foreign markets,
including, the home country markets of the foreign entities;
v. The issuing country's own financial institutions and other entities are able to issue in
foreign markets instruments denominated in that country's currency;
vi. International and regional financial institutions are able to issue debt instruments in
a country's market and use its currency in their financial operations;
vii. The currency may be included in the "currency baskets" of other countries, in
consideration of their own exchange-rate policies.
Measured against the above pre-requisites for internationalization of currency, Indian Rupee
is certainly far away from any meaningful internationalization. Of course, a few measures
taken in the recent years deserve some attention. Since the introduction of FEMA, the Indian
Rupee invoicing is a permitted form of invoicing under the current trade and FEMA
regulations. In order to facilitate greater use of Indian Rupee in trade transactions, the
Reserve Bank of India has now allowed non-resident importers and exporters to hedge their
currency risk in respect of exports from and imports to India, invoiced in Indian Rupees. In
this regard, forward foreign exchange contracts with Indian Rupee as one of the currencies
and foreign currency - Indian Rupee options are the available products for the purpose of
hedging the risks. Non-resident exporter/importer can avail of the facility either directly from
ADs in India or through their banker overseas. The AD, on the basis of the documentary
evidence and undertakings provided by the non-resident, has to be satisfied of the
bonafides of the customer as well as of the transaction. As with all other hedging facilities
available to non-residents, these contracts once cancelled cannot be rebooked. We would be
happy to have your feedback on this particular measure announced by the Reserve Bank of
India as it is almost nine months since the same was announced.
Eligible borrowers have been permitted to avail of ECBs designated in Indian Rupee from
their foreign equity holders under the automatic/ approval route. In order to hedge the
currency risk arising out of such ECBs, forward foreign exchange contracts with Indian
Rupee as one of the currencies, foreign currency-Indian Rupee options and foreign
currencyIndian Rupee swaps have been permitted.
The debate on internationalization of a currency often goes hand-in-hand with that on capital
account convertibility. It is a known fact that capital controls can co-exist with an international
currency. Economic history is rich with examples of countries, especially advanced countries
with an international currency, imposing a variety of capital controls to stem the
depreciation/appreciation of their currencies and/or to regulate short-term capital flows. While
internationalization of a currency is not a pre-requisite for capital account convertibility, its
large scale externalization has the potential to impose significant costs, especially over the
medium- to long-term as the real and financial sectors of a country grow and develop strong
linkages with the world economy.
The pace and the process of internationalization of a currency is of course dependent on the
acceptable degree of capital account convertibility. This, in turn, involves the extent to which
non-residents are allowed to participate in the domestic forward foreign exchange markets to
obtain cover and invest in the domestic markets for any Indian Rupee balances that they
may accumulate. At the same time, the benefits and costs of the Indian Rupee becoming an
international currency needs to be reckoned. The benefits broadly include reduction of
exchange risk for domestic exporters/importers as risks would instead have to be taken by
the overseas party and extensive use of Indian Rupee by non-residents would mean
increased seigniorage. Domestic entities can also access international financial markets
without exchange rate risk and can avail of larger amounts of investment at a lesser cost
than in the domestic market. Expanded investor base and reduction in the cost of capital may
help both the financial sector intermediation and the real sector. Governments, particularly
those with high fiscal deficit, may benefit by foreign participation in its debt market and get
the benefit of higher flows to finance the current account deficits. The costs would include
difficulty in managing the implications for monetary policy and exchange rate management
besides the administrative costs. Under the "Impossible Trinity" framework higher
internationalization would severely limit either the country's flexibility to influence the
monetary condition, such as, interest rate, money supply. or manage exchange rate under
stress situations. Coming to the issue of benefit to domestic entities/government by way of
easy access to external resources, the huge risk in terms of increased vulnerabilities arising
out of sudden stops, panic outflows unrelated to fundamentals of the economy, speculative
bets by large pools of international funds, loss of confidence in the context of size of reserves
in relation to external debt, particularly short term debt, have to be reckoned with. These
vulnerabilities have now been accentuated in the context of the recent global financial crisis.
It is also imperative to understand that unlike countries with current account surpluses, India
generally has a sizeable quantum of current account deficit. The exchange rate of Indian
Rupee remains susceptible to ebb and flow of external capital, especially outflows during
periods of stress. Given the growing level of our twin deficits of fiscal and current account
hasty internationalization could only add to our external sector vulnerabilities. As has been
witnessed in the past, sudden reversal of capital flow imparts significant volatility to the
exchange rate which at times needs to be curbed by the Reserve Bank. In the event of
internationalization of the Indian Rupee, the exchange rate would be largely determined by
the sentiments of the market forces and the present policy measures to curb such volatilities
may not prove to be as effective as they are today. These are some initial thoughts on the
subject which you would be discussing in detail tomorrow. We would look forward to
views/suggestions that would emerge from the deliberations of the panel here and thereafter,
particularly if we can identify some low risk but macro-economically beneficial areas, such
as, progressive use of Indian Rupee in trade account given the need to further boost to our
exports sector.
Concluding thoughts
Economy and financial markets of India are in the midst of rapid transformation due to its
increasing linkages with the rest of the world. In keeping with the changing needs, Reserve
Bank of India has been striving for more simplification, liberalization and rationalization of the
policies and the processes in the area of foreign exchange administration without
jeopardizing the financial stability. Market-players, therefore, now have more freedom to
undertake transactions as compared to the earlier days. These flexibilities, however, should
be utilized in a responsible manner that is transparent, fair and beneficial to the customers
and the economy as a whole and not mis-utilized for short term gains of a few market-players
with adverse consequential effects on our financial sector. Therefore, the role of FEDAI
assumes greater significance in the present context. There is, thus, a need to have a closer
look at the working and functions of FEDAI and strategize on how to transform it to a
fullfledged and responsive SRO. This would be a win-win proposition for all the stakeholders
including the banks, customers and the regulators like the Reserve Bank of India. I am sure
that the deliberations in this conference will generate practical ideas on the future role of
FEDAI, especially as we continue to make progress in our calibrated approach towards
capital account convertibility coupled with the measures being taken to deepen and broaden
our forex market and facilitate greater use of Indian Rupee, particularly in the trade account.
I wish you all the very best for productive business sessions followed by the pleasure of
exploring the sublime and scenic beauty of Switzerland.