Rundheersing Bheenick: The first Pan-African Derivatives Exchange in
Mauritius
Address by Mr Rundheersing Bheenick, Governor of the Bank of Mauritius, at The Seminar
on Currency Derivatives, organised by Global Board of Trade, Port Louis, 16 July 2009.
* * *
It is a great pleasure for me to be with you this morning at the opening ceremony of this
Seminar on Currency Derivatives, organized by the Global Board of Trade. The launch of the
first Pan-African Derivatives Exchange - which is what GBOT is - here in Mauritius marks a
milestone in the development of our financial sector. The waves of financial sector
liberalization first touched our shores in a big way in 1994 with the suspension of exchange
control which was how we had kept our external accounts in balance until then, supported
much of the time by steep import tariffs, administrative controls, lending ceilings and directed
interest rates.
Our financial sector has attracted favourable reviews from international financial institutions
and has emerged over the past few years as an important contributor to the economy. It has
also been a key driver in our efforts to participate fully in globalization, supported by other
measures such as tariff reduction and fiscal consolidation. In 2008, the financial sector was
the second-fastest growing area of activity, just after the booming construction sector, with a
growth rate of 10.1 per cent, against 7.5 per cent in 2007. It employed 12, 500 persons and
its share in GDP was just below 11 per cent. And this year, when the global economy has
stalled as Western economies have nosedived in what has been called the Great Recession,
our financial sector continues on its growth path. Its contribution to GDP is predicted to rise
to 11.5 per cent in 2009 and to keep rising thereafter as the contributions of traditional
sectors to GDP continue on their declining trend.
Although our financial sector witnessed an impressive development over the last decade
following the suspension of capital controls, the focus remained on sound bank lending,
securities issuances and trading, and foreign direct investment. We relied on domestic retail
deposits, not foreign wholesale money markets. We, as regulator and supervisor, did not fall
asleep at the wheel and our banks have continued to be profitable and have not become
wards of the state! Our financial system is of course far from perfect and suffers from several
deficiencies - e.g. markets for bonds, currency and derivatives are thin!
In a brief interview I had given to the "Business Standard" newspaper in India in March last
year, I said that even if our economy was suffering from a deluge of foreign exchange via
Foreign Direct Investment inflows, most of the foreign exchange operations were confined to
the spot market. I added that I wanted to encourage the development of a vibrant currency
futures and forward market. I took the view that such a development would help in creating
an active foreign exchange market and introduce newer instruments for exporters and
entrepreneurs to hedge and trade in the financial services sector.
Forward transactions accounted for less than one-fifth of total reported foreign exchange
transactions during the last two financial years. Of this, options comprised only a tiny fraction.
This was the prevailing situation despite the fact that, the Bank had authorised one bank to
engage in cross-currency options in major currency pairs with corporates as far back as
2003. Clearly, some more robust action was called for if we were to dampen the volatility
arising from over-reliance on a fairly thin forex spot market with too few players.
I have underscored on various occasions the importance of an efficient financial system to
sustain our growth as a small export-oriented economy, situated far from its main markets,
and forced by globalization and trade liberalization to compete without the protection of the
preferential trading arrangements which we relied on earlier to pay our way. It is a truism to
say that the financial system can be efficient only in so far as it has efficient financial markets
to support it. Let me borrow the image of a four-legged table from Randall Dodd , Director of
the Financial Policy Forum and Derivatives Study Centre, in Washington DC, to illustrate this
notion. His four-legged table is made up of (i) securities markets, which issue and trade
bonds and equity shares, (ii) banks which issue loans and provide payment and settlement
services, (iii) insurance and pension funds which provide future income and collateral for
lending, and (iv) derivatives markets, which facilitate risk management and price discovery.
Dodd concludes: "All four legs serve to support the table, and it is no more stable than its
weakest leg." Indeed! No wonder our table proved rather wobbly: one leg has been missing
all along!
Measures such as the elimination of centralised controls over prices and resource
distribution, trade liberalization, freeing nominal interest rates and abolishing exchange
controls, fundamentally alter the economic and financial risk exposures of financial
institutions and companies. They generate a demand for effective risk management products
that cover both liquidity and price risk. As the financial system develops, the sophistication of
financial products increases. Borrower and investor choice is widened; and products that
better match their specific requirements are more likely to be on offer, thus encouraging
greater use of the financial sector. In addition, financial products, like instruments with
market-determined returns (for example, government bonds), derivatives (for example,
financial futures), and foreign exchange products facilitate arbitrage that links prices across
time, markets, and countries.
Derivatives perform two economically-useful purposes: (i) risk shifting, also known as risk
management or hedging, and, (ii) price discovery, which is the process of determining the
price level for a commodity, asset or other item, based on supply and demand factors.
Derivatives provide excellent opportunities to hedge risk for different kinds of participants,
importers, export-oriented enterprises etc. Here, I have particularly in mind our dear
exporters, relentless and unabashed champions of sustained depreciation of our Rupee.
I am sure that once GBOT would have explained the complexities and risks of currency
derivatives and how those risks are mitigated, our economic operators and other market
players will appreciate that there would be commensurate reward for those who are willing to
assume the risk as for those who are seeking to shift the risk. A market for foreign exchange
hedging instruments can help domestic corporates in managing currency mismatches in their
assets and liabilities. Our banks can also become members of the exchange in the foreign
currency segment. In spite of the fact that forex futures, like all futures, are in the nature of a
zero-sum game, differences in risk appetites mean that there is a potential for win-win
outcomes all round.
Let me comment briefly on the evolution of the derivatives markets worldwide just to provide
some context. The latest BIS Triennial Central Bank Survey of Foreign Exchange and
Derivatives Market Activity shows that derivatives markets worldwide witnessed explosive
growth during the period covered, that is the three years from May 2004 to April 2007. The
OTC derivatives segment, the average daily turnover of interest rate, as well as
nontraditional foreign exchange contracts increased by 71 percent to USD 2.1 trillion over the
three-year period, maintaining an annual compound growth of 20 percent witnessed since
1995. Turnover of foreign exchange options and cross-currency swaps more than doubled to
USD0.3 trillion per day, outpacing the growth in "traditional" instruments such as spot trades,
forwards or plain foreign exchange swaps.
In the wake of the financial crisis, it has been found that the explosion of the derivatives
markets was partly due to speculation and an abuse and misuse of derivatives. The
ballooning of trade in derivatives across all categories to a staggering total of $596 trillion in
December 2007 was driven by strong speculative interest and did not reflect economic
fundamentals. In the two years to December 2007, currency derivatives grew by 78 per cent
to reach $56 trillion. The semiannual statistics on OTC derivatives of the BIS indicate that
currency derivatives had fallen to $50 trillion by December 2008. The growth in the market
for currency derivatives is likely to decline further as regulators contemplate limits on trade in
view of large losses which drove the South Korean won to a decade low; led to lawsuits in
India; and caused shares of China's Citic Pacific Ltd. to collapse. So, there is a downside and
it is as well that we should be aware of the potential dangers that lie ahead and that we
should guard against.
I must say that I have seen lately the first encouraging signs of the maturity of our exchange
arrangements: the recognition of the greater role assigned to market forces in determining
the exchange value of the Rupee. I have already mentioned recently the proposal of the IMF
to reclassify our exchange rate regime from "managed float" to "free float", based on our
performance in the recent past. We have come a very long way indeed since the collapse of
the Bretton Woods system of fixed exchange rates in 1971. Countries of our size were
paralysed by the fear of floating. They did not have the credibility to have independent
monetary and currency regimes. By being recognized as a free-floater, we have truly come
of age as an independent nation, with an independent currency.
As an aside, let me recall that currency futures, which we are discussing this morning, were
also made possible by the collapse of the system of fixed exchange rates. The Chicago
Mercantile Exchange launched the first forex future in 1972.
Let me make a few comments on our Exchange Rate Policy! Over the past year, the Bank
has limited its interventions in the foreign exchange market but we have nevertheless
ensured that the Rupee did not suffer from any undue volatility despite the spillover effects of
the financial turbulence in other parts of the world. If we are upgraded to the category of "free
floater", this would mean a continuation of our policy of limited intervention and would imply a
greater role to the market in managing the exchange rate. We expect that trade in currency
derivatives can assist this area, by relieving pressure on the spot market and contributing to
eradicate erratic and opportunistic behaviour, and thus reducing volatility.
The launch of a global derivatives exchange in our jurisdiction is yet another indication of the
growing sophistication of our financial system. I strongly believe that the domestic financial
market is now mature enough to engage in derivatives trading under proper regulation. I
would like to mention in the same breath the efforts of the Bank to develop a secondary
market for Treasury Bills and Bank of Mauritius Bills. This will add greater depth and liquidity
to the official paper segment of the market and perhaps pave the way for a bond and interest
rate futures market. Another initiative worth mentioning is the introduction of Islamic financial
services and the need for Islamic Treasury Products. Discussions have been ongoing with
GBOT for several months now to provide a platform for launching and trading such products.
Yesterday itself, the press reported that the Stock Exchange of Mauritius (SEM) and the
Central Depository & Settlement Co Ltd had approached the Financial Services Commission
to launch index futures trading, targeting the SEM-7 Index.
All these initiatives aim at remedying the deficiencies of our financial system to which I
alluded earlier and which need to be addressed to achieve greater financial system efficiency
and realize our ambition to become an international financial centre. The development of a
vibrant market for trading currency derivatives, not just for the domestic market but for the
region, is another element that would contribute to position Mauritius as a world-class
financial centre. It would help in forging deeper economic ties and strengthen our
commitment to regional integration. Such ties are mutually beneficial - for Mauritius they can
help to overcome the constraints posed by the small size of our domestic market and for our
regional partners in Africa, they can contribute to accelerate the pace of development.
Perhaps there can be no better testimony to our commitment to regional integration than the
determined drive by some of our major banks to expand their operations in the region. As the
process gathers momentum, others will follow suit; and currency derivatives are set to take
on greater importance in the risk management toolkit of our banks.
This seminar comes at a time when policy-makers across the world are reflecting deeply on
the role of the financial crisis in the global recession and the necessary changes to be made
to the financial system to make it more resilient. Amid the chaos and confusion surrounding
the debacle of the global financial system, it is important to remind ourselves of the role of
the financial sector in allocating resources and risks. We may disagree about the precise role
which complex financial instruments played in the financial crisis, but there is broad
agreement that the way forward is not a turning back of the clock of global finance, but for
better understanding by all market-players, including regulators, about the nature of
sophisticated financial instruments. This seminar is therefore both timely and pertinent in
enhancing our understanding of complex financial products, and in dispelling
misconceptions, as we prepare for recovery and transition to a new world order.
A word of caution: the regulator's perspective
One word of caution before concluding my remarks - while currency derivatives are hedging
products, and therefore, risk mitigating instruments, the absence or inadequacy of robust risk
management practices and oversight surrounding this activity could have disastrous
consequences. Our banks should therefore ensure that their dealers are well-trained, that
there are clear-cut controls on their operations, and that the activities are audited on a
concurrent basis, at least in the initial stages. While the exchange has the responsibility to
ensure against settlement risks, it is the institution concerned that must address the internal
procedural issues. Let us not forget that the scandals that affected such institutions as
Barings and Société Générale, although related to derivatives, had their origin in a failure of
the internal controls of the banks.
As much as the Bank of Mauritius recognizes the wealth of opportunities which the
development of a currency derivatives market can bring, we are also mindful of its potential
implications for financial stability. Derivative activities can contribute to build up vulnerabilities
and adverse market dynamics, particularly if the necessary supporting financial and legal
infrastructure is not in place. We would not have been here this morning, if the new
Insolvency Act had not made provision for the netting of financial contracts drawing on best
international practice in this area. This set the stage for the development of the derivatives
market in Mauritius. The mechanisms in place to ensure that these instruments are used to
hedge risks and not for speculative purposes must also be there.
To conclude, let me refer to the Bond-Currency-Derivatives nexus that Percy Mistry, Director
of Oxford International Group, had laid emphasis on in his Committee Report on converting
Mumbai into an International Financial Centre. He had indeed taken a similar position earlier
when he led a Commonwealth Secretariat team to Mauritius to examine ways and means to
dynamise the export of tradeable services. He concluded that Mauritius needed to "develop
the ability to provide such specialized international financial services with the knowledge and
skills set necessary to give it an added advantage in developing suitable financial derivative
(risk-hedging) contracts for African securities markets....and over time......Mauritius might
develop the ability to offer and trade more sophisticated derivative contracts.....".
Mistry provides the script for the derivatives play. We at the Bank of Mauritius consider the
development of a futures market one of our priorities to further our financial sector
development agenda, in collaboration with our sister-regulator, the Financial Services
Commission. The Bank and FSC have a major role which - to stay in the theatrical world -
may be likened to that of Lord Chamberlain - producer, controller and censor! So, here we
are with all the elements falling in place: the stage is set; the playwright's script has been
passed; the Lord Chamberlain is watching over everything; the players are busy rehearsing
their roles and learning their lines (which is what the seminar is all about); and the curtain will
soon go up. Excited and expectant, I say to all of you: let the show begin. I wish GBOT and
all players every success in this endeavour.
Thank you for your attention.