Shyamala Gopinath: Some reflections on the recent global financial
turmoil - an Indian perspective
Keynote address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India,
at the Annual Conference of the Foreign Exchange Dealers' Association of India (FEDAI),
Kolkata, 10 January 2009.
Assistance of Mr. Vaibhav Chaturvedi in preparation of the remarks is gratefully acknowledged.
* * *
Every year, this forum provides an opportunity to collectively review and analyse the
developments of the past year in the forex market. But the past year has been like never
before and now the focus is on the impact of the financial crisis on the real economy. The
financial meltdown has resulted in effective nationalisation of major financial institutions in
the US, UK and Eurozone. So far global banks, mortgage lenders and insurance firms have
announced write downs of over US$ 800 billion. There has been a massive increase in
central bank lending to the banking system and rescue packages totalling almost US$3
trillion have been announced by governments around the world. Monetary policy has been
eased aggressively but given the lagged impact attention has shifted to fiscal policy. From
this side, I can say that the past year has indeed been a challenging one which has
reinforced the futility of finding clean corner solutions to evolving situations and each decision
necessarily involves managing different objectives while finding the immediate focus points
without dissipating the gains of reforms undertaken.
Forex markets in India - recent developments
2. As far as the Indian foreign exchange market is concerned, during the last five years the
sources of supply and demand have changed significantly with large transactions emanating
from capital account unlike in the past when current account transactions dominated the
foreign exchange market. The behaviour as well as the incentive structure of the participants
who use the forex market for undertaking current account transactions differ significantly
from those who use the market for capital account transactions. Therefore managing the
capital account, particularly debt flows, even while we are getting more integrated is an
important instrument in our overall macroeconomic management. In the last few years we
had to address the challenge of large capital inflows and had therefore in consultation with
Government taken certain measures to calibrate these flows by requiring external
commercial borrowings (ECB) to be used for foreign currency expenditure. Measures to
liberalise outflows for resident individuals, mutual funds, and corporates were also pursued.
The global financial crisis and deleveraging have now led to reversal and / or modulation of
capital flows particularly foreign institutional investor flows, ECBs and trade credit.
3. In response to the emerging global developments, the RBI has taken a series of measures
to augment forex and domestic liquidity. Some of the measures taken to augment forex
liquidity are:
•
USD dollar swap lines of up to USD10 billion for Indian banks with overseas
branches and subsidiaries. The actual utilisation, as of January 7, 2009 is only
USD 247 million.
•
Increasing interest rate ceilings for FCNR(B) and NRE deposits to LIBOR / SWAP
rates plus 100 basis points and LIBOR / SWAP rates plus 175 basis points
respectively.
•
ECB policy, which is an instrument of capital account management, has been
liberalised to revert to the pre-May 2007 period. It may be recalled that due to large
capital flows, the end use of ECB proceeds was limited to foreign currency
expenditures. Further liberalisation in terms of expanding eligible borrowers and end
use has also been undertaken viz:
Housing Finance Companies, registered with National Housing Bank (NHB)
o
have been permitted to raise short-term foreign currency borrowings
o NBFCs, which are exclusively involved in financing of the infrastructure
sector, may avail of ECBs from multilateral / regional financial institutions
and Government owned development financial institutions for on-lending to
the borrowers in the infrastructure sector under the Approval route.
o Payment for obtaining license/permit for 3G Spectrum will be considered an
eligible end-use for the purpose of ECB.
o The corporates in the Hotels, Hospitals and Software sectors to avail of
ECB up to USD 100 million per financial year, under the Automatic Route,
for foreign currency and / or Rupee capital expenditure for permissible
enduse.
o Spreads on ECBs and trade credits were increased and the all-in-cost
ceilings on ECBs were dispensed with under the Approval route.
•
Limit on overseas borrowings by banks was enhanced from 25 percent to 50
percent of unimpaired Tier I capital. Overseas borrowings for on-lending to exporters
continue to remain outside the ceiling.
•
In order to enable EXIM bank to continue to offer buyers credit against lines of credit
as well as preshipment and post shipment finance, RBI has extended a line of credit
of Rs 5000 crore.
•
EXIM is also eligible to avail of swap facility up to USD 1 billion under the facility
permitted for banks.
•
The FII limit for investment in corporate bonds has been hiked to USD 15 billion
from USD 6 billion.
4. The Indian foreign exchange market has grown significantly in the last several years. The
daily average turnover has gone up from about USD 5 billion per day in 1998 to more than
USD 50 billion per day in 2008. There is also evidence of growing merchant turnover
reflecting the huge increase in external transactions. The bid offer spreads are also narrow.
5. The spot foreign exchange market remains the most important segment but the derivative
segment has also grown. In the derivative market foreign exchange swaps account for the
largest share of the total turnover of derivatives in India followed by forwards and options.
Significant milestones in the development of derivatives market have been (i) permission to
banks to undertake cross currency derivative transactions subject to certain conditions
(1996) (ii) allowing corporates to undertake long term foreign currency swaps that contributed
to the development of the term currency swap market (1997) (iii) allowing dollar rupee
options (2003) and (iv) introduction of currency futures (2008). I would like to emphasise that
currency swaps allowed companies with ECBs to swap their foreign currency liabilities into
rupees. However, since banks could not carry open positions the risk was allowed to be
transferred to any other resident corporate. Normally such risks should be taken by
corporates who have natural hedge or have potential foreign exchange earnings. But often
corporate assume these risks due to interest rate differentials and views on currencies.
This period has also witnessed several relaxations in regulations relating to forex markets
and also greater liberalisation in capital account regulations leading to greater integration
with the global economy.
6. Cash settled exchange traded currency futures have made foreign currency a separate
asset class that can be traded without any underlying need or exposure and on a leveraged
basis on the recognized stock exchanges with credit risks being assumed by the central
counterparty. Since the commencement of trading of currency futures in all the three
exchanges, the value of the trades has gone up steadily from Rs 17,429 crores in October
2008 to Rs 45,803 crores in December 2008. The average daily turnover in all the
exchanges has also increased from Rs 871 crores to Rs 2,181 crores during the same
period. The turnover in the currency futures market is in line with the international scenario,
where I understand the share of futures market ranges between 2-3 per cent.
The broader theme
7. In my remarks today I thought it would be appropriate and relevant to touch upon the big
picture and underline some lessons that we can draw from the crisis relevant to regulation,
financial markets and the market infrastructure and reflect on these. We will continue to learn
from the lessons as the crisis is still evolving but these are certain topical issues.
(i) As was to be expected, the financial sector turmoil has triggered a reassessment
internationally of the existing theoretics and metrics about the financial sector
developments of the past two decades and the simultaneous evolution of the global
regulatory framework enshrined in the Basel framework. Questions are being asked
and answers being sought to some of the key issues regarding leverage,
transparency, and liquidity underlying at the heart of the crisis.
(ii) What the current crisis has done is to question the very fundamentals of the entire
financial framework. What is the role of the financial system in an economy vis-à-vis
the real sector? If the financial sector exists, as traditionally conceived to
intermediate financial resources for optimal channelisation to productive sectors,
then over the last few years the script has gone terribly bad. The world of finance, as
had come to be epitomized in the market volumes and turnovers and derivative
outstandings got disconnected by far from the real sector.
(iii) The importance of containing systemic leverage has been underlined. While
obviously there can't be market stops and starts for this purpose but the whole
incentive structure built in the public policy framework needs to be aligned with the
objective of disincentivising leverage beyond a point. Any future financial market
reform measure and introduction of new innovations/products must be preceded by
an assessment of the resultant leverage for the system in quantifiable terms.
(iv) Financial sector entities need to be seen and regulated as risk repositories in the
system - any notion of their risks being dissipated into or outside the system is
inherently flawed. There is therefore need for limits, prudential safeguards and
adequate capital to support the risks. It is also necessary to understand the
substance of a product and not merely the nomenclature.1 Once this understanding
is there the income recognition and accounting treatment becomes clear. Receipt of
premia/fees for assuming a contingent liability will then not be treated as income but
as funds for meeting potential future liabilities.
(v) It is now recognised that the current microeconomic-driven prudential regulatory
framework, including Basel II is procyclical which further worsens the impact of
crises on institutions. In 2000, the Bank of Spain introduced a dynamic, rules-based
loan-loss provisioning system in which provisions increase in periods of higher credit
growth and economic expansion, and decrease in times of low or negative growth,
thereby contributing to smooth income and capital over time. RBI also did something
similar when we increased the risk weight as also the general provisioning
requirement on exposures to sectors which showed high credit growth. This was
reduced recently when growth moderated.
(vi) The increasing focus on holistic approach towards regulation of financial entities is a
welcome change from the view that allowed a growing proportion of products and
participants to go unregulated on the grounds that they had no systematic impact.
This approach resulted in the shadow banking system made up of unregulated SIVs
and conduits distributing opaque structured products containing risky assets with the
active marketing of rating agencies.
In India also, one view used to be that only deposit taking NBFCs need regulation to
protect the interest of depositors and that the non-deposit taking NBFCs do not pose
any such risk and therefore need not be regulated. It was, however, realised that the
inter-linkages of these NBFCs with the other components of the financial system
have grown over the years and their growing presence in various financial markets
could, in the absence of regulatory steps lead to risk transfers which could have
systemic implications. You are well aware how in the recent past, through a gradual
non-disruptive process, an attempt has been made to bring systemically important
non-deposit taking NBFCs under a more harmonised regulatory framework,
including the capital adequacy norms and exposure norms. These measures have
reduced the unlimited leverage possibilities available to NBFCs.
(vii) Another important aspect has been the treatment of off balance sheet exposures
and consolidation of off balance sheet vehicles and conduits. While applying
prudential norms, there is need to treat off-balance sheet transactions similar to on
balance sheet transactions for the purpose of capital adequacy norms and risk
management. In the case of off balance sheet vehicles a broader view needs to be
taken from a prudential point of view on consolidation. The critical issue should be
not merely the ownership but where the risk resides. In this context, a review of the
current conversion factors and risk weights for off balance sheet items is necessary.
Similarly it is recognized that the potential liquidity risks also need to be captured.
Pursuant to the announcement in the Annual Policy Statement of April 2008, the RBI
over a period and after consultations with market participants has announced the
following measures:
o Strengthening of the capital adequacy norms for off balance sheet
transactions covering foreign exchange and interest rate exposures. It
mandated use of current exposure method for measuring the credit
equivalent amount i.e. the exposures had to be marked to market, and
prescribed provisioning requirement for the exposure amount as applicable
to standard assets of the concerned counterparty. Credit conversion factors
were also increased across maturities.
o In regard to asset classification it was clarified that the amount due on a
derivative contract will be treated as NPA if not received within 90 days. In
that case all other funded facilities granted to the client will also be
classified as non-performing asset following the principle of borrower-wise
classification as per the existing asset classification norms. However, in the
case of complex derivative contracts that were entered into between April
2007 and June 2008, the RBI suggested that the unpaid amounts may be
parked in a separate account and borrower wise classification will not
apply.
In cases where a derivative contract is restructured, the MTM value of the
o
contract on the date of the restructuring should be cash settled.
(viii) While the factors responsible for the crisis are many, one that is being debated
widely is the contribution of fair value accounting framework for complex and
conventional financial instruments in amplifying the crisis. The problem lies in the
procyclical nature of the standard and the difficulty in valuing financial instruments
when markets are illiquid or in distressed conditions.
Although fair value may increase transparency of the company accounts, it may not
always reflect the true intrinsic value in both upswings and under excessively
stressed market conditions. There is a need to distinguish the basic financial and
prudential analysis from a purely "financial" accounting framework.
There is also need to clearly appreciate that the accounting reporting has a role as a
source of information and as such will indicate the value of the company at the
moment of the statement of accounts. Fair value for prudential purposes is more
forward looking in its approach as it includes not only incurred losses but also
expected losses. This tension can be addressed by the regulators addressing the
regulatory and prudential aspects in the case of banks. Keeping in view the systemic
implications of the standards, regulators will have to carry out an indepth
assessment of the concepts and tools relating to valuation.
(ix) Great emphasis is now being laid on implementing a central counterparty for OTC
derivatives particularly for credit default swaps. Well regulated counterparties reduce
potential for disruption in financial markets and promote operational efficiencies and
transparency.
In India as early as in 2001, the Clearing Corporation of India was set up to settle
interbank spot forex transactions and all outright and repo transactions in
government securities whether negotiated or order driven systems. CCIl has also
introduced a collateralised money market instrument called CBLO which is also
settled through the CCP. CCIL has also commenced non-guaranteed settlement of
OTC trades in interest rate swaps on 27 November 2008. Guaranteed settlement of
these trades will commence later once we clarify the exposure requirements. In the
near future it will also act as central counterparty for forward contracts which will
mitigate risks releasing counterparty exposure limits. The margins are in the form of
cash and government bonds ensuring the quality and liquidity of the settlement
guarantee fund
(x) Recent developments will also pave the way for more effective regulation rather than
reliance on self regulation, credit rating agencies assessments or setting of
standards by industry participants.
(xi) Lastly, on the issue of selling of complex products, we have to collectively work
towards a viable framework. What is the solution? In this context I would like to
recount the application of a surprisingly simple idea to the realm of public policy that
has received tremendous attention after being advocated by Richard Thaler and
Cass Sunstein in their international bestseller "Nudge". The authors advocate the
use of "choice architecture" by businesses or governments to influence choices in
ways that encourage choosers to make decisions in their best interest. They call it
"libertarian paternalism". This involves utilizing "nudges" such as the wording of
choices in ways that influence individual actions, designing default choices (in the
absence of action) that do not penalize individuals, limiting choices to those that are
more comprehensible, taxing detrimental choices, and providing full disclosure to
better inform decision-makers. Can we take a cue?
I will urge FEDAI to take it up as a special assignment and suggest a framework that
is both practical and implementable while ensuring the best interests of all
stakeholders.
8. The experience and lessons of the present crisis will be extremely useful for us in going
forward with the process of financial market liberalisation. While there is not and should not
be any stifling of innovations in the financial sector, it is important to distinguish financial
innovation from conventional product, service or process innovation in terms of the systemic
costs these entail. Socially useful as it is, financial innovation should not be allowed to
outpace its understanding by the multitude of market participants and stake holders - a
process facilitated by appropriate reporting, accounting and governance standards and
enforced by regulatory and supervisory regime.
9. FEDAI plays a special role in the foreign exchange market for ensuring smooth and
speedy growth of the market in all its aspects. All authorised dealers are required to become
members of the FEDAI and execute an undertaking to the effect that they would abide by the
terms and conditions stipulated by the FEDAI for transacting foreign exchange business. As
the forex market grows in the spot and derivative segments including currency futures, the
FEDAI as a self regulatory organisation needs to focus on supporting orderly growth,
promoting market integrity and sound practices with the ultimate objective of supporting the
real economy. I wish the conference all success.