The document discusses the growth of foreign exchange markets in India since liberalization in the early 1990s. It notes that monthly trading volumes have grown over ten times from 2003-2004 to over $359 billion in 2005-2006, making it one of the largest financial markets in India. The market is dominated by inter-bank trading among over 90 authorized dealers, mostly banks. Foreign exchange regulation has been replaced with more flexible rules, and India has moved to a managed floating exchange rate system while accumulating large foreign reserves.

1. Foreign Exchange Markets
Rajesh Chakrabarti*
Introduction
During 2003-04 the average monthly turnover in the Indian foreign exchange
market touched about 175 billion US dollars. Compare this with the monthly trading
volume of about 120 billion US dollars for all cash, derivatives and debt instruments put
together in the country, and the sheer size of the foreign exchange market becomes
evident. Since then, the foreign exchange market activity has more than doubled with the
average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the
daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,
foreign exchange constitutes the largest financial market by far.
Liberalization has radically changed India’s foreign exchange sector. Indeed the
liberalization process itself was sparked by a severe Balance of Payments and foreign
exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system
replete with severe import and foreign exchange controls and a thriving black market is
being replaced with a less regulated, “market driven” arrangement. While the rupee is
still far from being “fully floating” (many studies indicate that the effective pegging is no
less marked after the reforms than before), the nature of intervention and range of
independence tolerated have both undergone significant changes. With an over-
abundance of foreign exchange reserves, imports are no longer viewed with fear and
skepticism. The Reserve Bank of India and its allies now intervene occasionally in the
foreign exchange markets not always to support the rupee but often to avoid an
*
College of Management, Georgia Tech, 800 West Peachtree Street, Atlanta, GA 30332, USA. Email:
rajesh.chakrabarti@mgt.gatech.edu .
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2. appreciation in its value. Full convertibility of the rupee is clearly visible in the horizon.
The effects of these development s are palpable in the explosive growth in the foreign
exchange market in India.
Foreign Exchange Markets in India – a brief background
The foreign exchange market in India started in earnest less than three decades
ago when in 1978 the government allowed banks to trade foreign exchange with one
another. Today over 70% of the trading in foreign exchange continues to take place in the
inter-bank market. The market consists of over 90 Authorized Dealers (mostly banks)
who transact currency among themselves and come out “square” or without exposure at
the end of the trading day. Trading is regulated by the Foreign Exchange Dealers
Association of India (FEDAI), a self regulatory association of dealers. Since 2001,
clearing and settlement functions in the foreign exchange market are largely carried out
by the Clearing Corporation of India Limited (CCIL) that handles transactions of
approximately 3.5 billion US dollars a day, about 80% of the total transactions.
The liberalization process has significantly boosted the foreign exchange market
in the country by allowing both banks and corporations greater flexibility in holding and
trading foreign currencies. The Sodhani Committee set up in 1994 recommended greater
freedom to participating banks, allowing them to fix their own trading limits, interest
rates on FCNR deposits and the use of derivative products.
The growth of the foreign exchange market in the last few years has been nothing
less than momentous. In the last 5 years, from 2000-01 to 2005-06, trading volume in the
foreign exchange market (including swaps, forwards and forward cancellations) has more
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3. than tripled, growing at a compounded annual rate exceeding 25%. Figure 1 shows the
growth of foreign exchange trading in India between 1999 and 2006. The inter-bank
forex trading volume has continued to account for the dominant share (over 77%) of total
trading over this period, though there is an unmistakable downward trend in that
proportion. (Part of this dominance, though, result s from double-counting since purchase
and sales are added separately, and a single inter-bank transaction leads to a purchase as
well as a sales entry.) This is in keeping with global patterns.
[Figure 1 about here]
In March 2006, about half (48%) of the transactions were spot trades, while swap
transactions (essentially repurchase agreements with a one-way transaction – spot or
forward – combined with a longer- horizon forward transaction in the reverse direction)
accounted for 34% and forwards and forward cancellations made up 11% and 7%
respectively. About two-thirds of all transactions had the rupee on one side. In 2004,
according to the triennial central bank survey of foreign exchange and derivative markets
conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee
featured in the 20th position among all currencies in terms of being on one side of all
foreign transactions around the globe and its share had tripled since 1998. As a host of
foreign exchange trading activity, India ranked 23rd among all countries covered by the
BIS survey in 2004 accounting for 0.3% of the world turnover. Trading is relatively
moderately concentrated in India with 11 banks accounting for over 75% of the trades
covered by the BIS 2004 survey.
Features of the Forward premium on the Indian rupee
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4. The Indian rupee has had an active forward market for some time now. The
forward premium or discount on the rupee (vis-à-vis the US dollar, for instance) reflects
the market’s beliefs about future changes in its value. The strength of the relationship of
this forward premium with the interest rate differential between India and the US – the
Covered Interest Parity (CIP) condition – gives us a measure of India’s integration with
global markets. The CIP is a no-arbitrage relationship that ensures that one cannot borrow
in a country, convert to and lend in another currency, insure the returns in the original
currency by selling his anticipated proceeds in the forward market and make profits
without risk through this process.
Chakrabarti (2006) reports tha t between late 1997 and mid-2004 the average
discount on the rupee was about 4% per annum. During the period the average difference
between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was
about 4.5% for 3-months and 3.5% for the 6- months period. With these two figures in the
same ballpark (particularly given that bank deposit rates and inter-bank rates are not
strictly comparable), annual averages of interest rate differences and the forward
exchange premium also indicate a moderate degree of co- movement between the two
variables. The interest rate differential explains about 20% of the total variation in the
forward discount. The deviation of the Indian rupee-US dollar from the covered interest
parity, however, exhibits long-lived swings on both sides of the zero line. This would
indicate arbitrage opportunities and market imperfections provided we could be sure of
the comparability of the interest rates considered. Therefore, while the behavior of the
forward premium on the Indian rupee is broadly in lines with the CIP, more careful
empirical analysis involving directly comparable interest rates is necessary to measure
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5. the strength of the covered interest parity condition and the efficiency of the foreign
exchange market.
Under market efficiency, the forward exchange rate is considered to be an
unbiased predictor of the future spot rate, with random prediction errors. While the
prediction errors of forward rates on the rupee appear to show some degree of
persistence, any conclusion in this matter too must await more rigorous analysis.
Intervention in Foreign Exchange Markets
The two main functions of the foreign exchange market are to determine the price
of the different currencies in terms of one another and to transfer currency risk from more
risk-averse participants to those more willing to bear it. As in any market essentially the
demand and supply for a particular currency at any specific point in time determines its
price (exchange rate) at that point. However, since the value of a country’s currency has
significant bearing on its economy, foreign exchange markets frequently witness
government intervention in one form or another, to maintain the value of a currency at or
near its “desired” level. Interventions can range from quantitative restrictions on trade
and cross-border transfer of capital to periodic trades by the central bank of the country
or its allies and agents so as to move the exchange rate in the desired direction. In recent
years India has witnessed both kinds of intervention though liberalization has implied a
long-term policy push to reduce and ultimately remove the former kind. It is safe to say
that over the years since liberalization, India has allowed restricted capital mobility and
followed a “managed float” type exchange rate policy.
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6. During the early years of liberalization, the Rangarajan committee recommended
that India’s exchange rate be flexible. Officially speaking, India moved from a fixed
exchange rate regime to “market determined” exchange rate system in 1993. The overt
objective of India’s exchange rate policy, according to various policy pronouncements,
has been to manage “volatility” in exchange rates without targeting any specific levels.
This has been hard to do in practice.
The Indian rupee has had a remarkably stable relationship with the US dollar.
Meanwhile the dollar appreciated against major currencies in the late 90’s and then went
into an extended decline particularly during 2003 and 2004. The lock-step pattern of the
US dollar and the Rupee is best reflected in the movements in the two currencies against
a third currency like the Euro. The correlation of the exchange rates of the two currencies
against the Euro during 1999-2004 was 0.94. Several studies have established the pegged
nature of the rupee in recent years (see Chakrabarti (2006) for a more detailed
discussion). Based on volatility, India had a de facto crawling peg to the US dollar
between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995,
with a major devaluation in March 1993. From mid-1995 to end-2001, the rupee reverted
to a crawling peg arrangement in practice. An analysis of the ratio of the variance of the
exchange rate to the sum of the variances of the interest rate and the foreign exchange
reserves reveals a move even closer to the fixed exchange rate system. A comparison of
the sensitivity (beta) of the Dollar-rupee rate with the Euro-rupee rate for a three year
period (1999 through 2001), indicates that India had a dollar beta of 1.01 – tenth highest
among the 53 countries considered. More importantly, the US dollar-Euro exchange rate
explained about 97% of all movements in the Indian rupee-Euro exchange rate – highest
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7. among all the 53 countries considered. Clearly the Indian rupee has been an excellent
“tracker” of the US dollar.
It is instructive to consider the Rupee-Dollar exchange rate in the light of the
purchasing power parity (PPP) holding that the exchange rate between two currencies
should equal the ratio of price levels in two countries. In its dynamic form PPP holds that
that the rate of depreciation of a currency should equal the excess of its inflation rate to
that in the other country. Over a reasonably long period of time, the devaluation in the
Indian Rupee, vis-à-vis the US dollar does seem to have an association with the
difference in the inflation rates in the two countries. Between 1991 and 2003, the two
variables have had visible co- movements with a correlation of about 0.57 (Chakabarti
(2006)). This may be a result of Indo-US trade flows dominating the exchange rate
markets but it is perhaps more likely that it reflects the exchange rate management
principles of the monetary authorities
The Reserve Bank of India has used a varied mix of techniques in intervening in
the foreign exchange market – indirect measures such as press statements (sometimes
called “open mouth operations” in central bank speak) and, in more extreme situations,
monetary measures to affect the value of the rupee as well as direct purchase and sale in
the foreign exchange market using spot, forward and swap transactions (see Ghosh
(2002)). Till around 2002, the measures were mostly in the nature of crisis management
of saving-the-rupee kind and sometimes the direct deals would be repeated over several
days till the desired outcome was accomplished. Other public sector banks, particularly
the SBI often aided or veiled the intervention process.
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8. The exact details of the interventions are shrouded in mystery, not unusual for
central banks ever wary of disclosing too much of their hand to the currency speculators.
The Tarapore Committee report had urged more transparency in the intervention process
and recommended, in 1997, that a ‘Monitoring Exchange Rate Band’ of ± 5% be used
around an announced neutral real effective exchange rate (REER), with weekly
publication of relevant figures, something yet to be implemented. In a recent survey on
foreign exchange market intervention in emerging markets, the Bank for International
Settlements (BIS (2005b)) found that out of 11 emerging market countries considered,
India gave out most complete information on intervention strategy (along with three
others); no information on actual interventions (five others did the same) and did not
cover foreign exchange intervention in annual reports (like two other countries). On the
whole it ranked fourth most opaque in matters of foreign exchange intervention among
the eleven countries compared.
Regulation of cross-border currency flows
A feature of the economy that is intricately related with the exchange rate regime
followed is the freedom of cross-border capital flows. This relationship comes from the
so-called “impossible trinity” or “trilemma” of international finance, which essentially
states that a country may have any two but not all of the following three things – a fixed
exchange rate, free flow of capital across its borders and autonomy in its monetary
policy. Since liberalization, India has been having close to a de facto peg to the dollar and
simultaneously has been liberalizing its foreign currency flow regime.
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9. Close on the heels of the adoption of market determined exchange rate (within
limits) in 1993 came current account convertibility in 1994. In 1997, the Tarapore
committee, on Capital Account Convertibility, defined the concept as “the freedom to
convert local financial assets into foreign financial assets and vice versa at market
determined rates of exchange ” and laid down fiscal consolidation, a mandated inflation
target and strengthening of the financial system as its three main preconditions.
Meanwhile capital flows have been gradually liberalized, allowing, on the inflow side,
foreign direct and portfolio investments, and tapping foreign capital markets by Indian
companies as well as considerably better remittance privileges for individuals; and on the
outflow side, international expansion of domestic companies. In 2000, the infamous
Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign
Exchange Management Act (FEMA) that gave participants in the foreign exchange
market a much greater leeway.
The ultimate goal of capital account convertibility now seems to be within the
government’s sights and efforts are on to chalk out the roadmap for the last leg, though it
is not expected to be accomplished before 2009. Expectedly, the wisdom of the move has
been hotly debated . Advocates of convertibility cite the “consumption smoothing”
benefits of global funds flow and point out that it actually improves macroeconomic
discipline because of external monitoring by the global financial markets. Convertibility
can spur domestic investment and growth because of easier and cheaper financing. It can
also contribute to greater efficiency in the banking and financial systems. On the other
hand, skeptics like Williamson (2006), for instance, points out that India is yet to fulfill at
least one of the three major preconditions to Capital Account Convertibility set out by the
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10. Tarapore committee, viz. fiscal discipline, with a public sector deficit of 7.6% of the GDP
and the ratio of public debt to GDP of over 83% in 2005-06. In any case, the argument
goes, the benefits of convertibility do not necessarily outweigh the risks and cross-border
short-term bank loans – usually the last item to be liberalized – are the most volatile. It is
generally held that it was, in fact, the lack of convertibility that protected India from
contamination during the Asian contagion in 1997-98.
The Dynamics of Swelling Reserves
An important corollary of India’s foreign exchange policy has been the quick and
significant accumulation of foreign currency reserves in the past few years. Starting from
a situation in 1990-91 with foreign exchange reserves level barely enough to cover two
weeks of imports, and about $32 billion at the beginning of 2000, India’s foreign
exchange position rocketed to one of the largest in the world with over $155 billion in
mid-2006. Since 2000, this implies a compounded annual growth rate of about 28% with
the years 2003 and 2004 having the most stunning rises at 48% and 45% respectively.
During these two years the US dollar fell against the Euro by 19% and against the rupee
by 9%. Without RBI intervention, the latter figure is likely to have been larger and the
reserves accumulation less spectacular.
A sizable foreign exchange reserve acts as liquidity cover and protects against a
run on the country’s currency, and reduces the rate of interest on Indian debt in the world
market by lowering the country risk perception by international rating agencies.
However, beyond a point, it begins to affect the money supply in the country, and interest
rates. There are significant “sterilization costs” to avoid this and the RBI loses money by
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11. earning low returns on the safe assets used to park the reserves. Given this low rate of
return, there has been discussion about the unique proposal to use part of the reserves to
fund infrastructure projects.
Outlook
Liberalization has transformed India’s external sector and a direct beneficiary of
this has been the foreign exchange market in India. From a foreign exchange-starved,
control-ridden economy, India has moved on to a position of $150 billion plus in
international reserves with a confident rupee and drastically reduced foreign exchange
control. As foreign trade and cross-border capital flows continue to grow, and the country
moves towards capital account convertibility, the foreign exchange market is poised to
play an even greater role in the economy, but is unlikely to be completely free of RBI
interventions any time soon.
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12. References
Bank for International Settlements, 2005a. Triennial Central Bank Survey: Foreign
exchange and derivatives market activity in 2004, Basel, Switzerland.
Bank for International Settlements, 2005b. Foreign exchange market intervention in
emerging markets: motives, techniques and implications, BIS Paper No.24, Basel,
Switzerland.
Chakrabarti, Rajesh, 2006. The Financial Sector In India: Emerging Issues, Oxford
University Press, New Delhi, 2006.
Ghosh, Soumya Kanti, 2002. RBI Intervention in the Forex Market: Results from a Tobit
and Logit Model Using Daily Data, Economic and Political Weekly, June 15,
pp.2333-2348.
Williamson, John, 2006, Why Capital account Convertibility in India is Premature,
Economic and Political Weekly, May 13, pp.1848-1850.
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13. Monthly forex trade in billion USD
(including derivatives and fwd cancellations)
0
100
200
300
400
500
600
May-99
August-99
Source: RBI Bulletins
November-99
February-00
May-00
* Not corrected for double counting
August-00
November-00
February-01
May-01
August-01
November-01
13
February-02
May-02
August-02
Fig. 1:
Time
November-02
February-03
May-03
Forex Trading activity
August-03
November-03
February-04
May-04
Merchant trade volume
Inter-bank trade volume*
August-04
November-04
February-05
May-05
August-05
November-05
February-06