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Friday, October 17, 2003

In the 'hot-seat'

Tamal Bandyopadhyay is worried abot the so-called hot-money. The difficulty is in deciding what here constitutes 'hot money'. The dollar is embarking on a secular (historic) decline. The Rupee (and later the Renminbi) are embarking on a secular (historic) rise. The general tendency will be up. There will of course be 'corrections' and this is where the flow of funds in-and-out which Tamal affectionately calls 'hot money' becomes important. India needs free currency markets. Long-term it can only gain from this. Short-term it needs to remove the distorting restrictions which, in the final analysis, give rise to the problem. Meantime, the time honoured solution to a rising currency is a reduction in interest rates. Internationally we are in a disinflationary - not an inflationary - environment.

On Monday, the value of the October 31 dollar was Rs 45.25 while the October 15 dollar was trading at Rs 45.40. In other words, if a bank entered into a sell-buy swap with another entity (that is, selling spot dollar - giving delivery on October 15 - and buying the October 31 forward dollar), it would have made a net gain of 15 paise or 7.53 per cent annually. If this money was deployed in the overnight market or put in the Reserve Bank of India's (RBI's) repurchase (repo) window, the bank would have earned 4.5 per cent on this money. So the bank would have gained a cool 12.03 per cent interest on a 15-day dollar kitty. Unprecedented gains of this kind have become possible because the rupee premium on the forward dollar has vanished - the greenback in the forwards market is now traded at a discount. On Monday, in actual terms, October-end forwards were sold at a discount of 15 paise, November 14 paise, December 12 paise, January 10 paise and so on.

The September 2004 forwards were traded at a one paise discount. This means the rupee value of dollar in September-end 2004 is Rs 45.39 while the spot dollar was trading at Rs 45.40! This marks the first time since the liberalisation of the Indian financial sector that the forward dollar is trading at a discount. This defies all financial logic. Traditionally, the currency with a higher interest rate is always traded at a discount in the forwards market vis-a-vis the currency with a lower interest rate. Forward premiums reflect the interest rate differential between the US and India. If that is the case, since US interest rates are lower than that prevailing in India, forward dollars should always command a rupee premium.

Why are forwards crashing and trading at a discount? This is because, apart from the interest rate differential, forwards also factor in domestic money market conditions and the outlook on the dollar. There is all-round bullishness on the rupee. Foreign institutional investors (FIIs) are pouring in money as if there is no tomorrow; the outlook for foreign direct investment (FDI) is also bullish given the signs of an economic turnaround. Many positive factors have pushed high oil prices, the burgeoning fiscal deficit and rising inflation into the background.

So what are we seeing? Exporters are in a mad rush to bring back their export proceeds and sell them to banks because they feel if they delay, the value of the dollar will drop in rupee terms. Importers think the same way, so they do not feel the need to cover their position by booking forward contracts. Even companies that have raised foreign currency loans overseas or taken dollars from banks through the foreign currency non-resident (bank) or FCNR(B) accounts are selling dollars in the market because they are confident that they can buy dollars by spending fewer rupees to clear their future dollar liabilities.

These dollars are being sold to banks. However, banks or authorised dealers (or ADs) cannot build dollar positions because the entire banking industry's open position on dollar is capped between $ 1.5 billion and $ 2 billion. So the banks in turn sell these dollars to the RBI. The net result of this is manifold. First, the RBI's dollar kitty is swelling. The country's foreign currency assets stood at $ 87.73 billion as on October 3. This is after the redemption of the Resurgent India Bonds.

Banks are feverishly buying in the spot market and selling forwards fearing a drying up of cash dollars because of the RBI's dollar mop-up. Finally, as supply outstrips demand, forward dollars are being traded at a discount instead of at a premium. The rise of the rupee is not an aberration since all global currencies are rising against the dollar. But the trend of forwards trading at a discount is an anomaly and needs to be corrected. To do that, the RBI may need to look into some structural issues. One way of tackling this could have been through creation of a dollar liquidity adjustment facility (LAF) like the existing rupee LAF whereby banks can borrow rupee resources if they need and, conversely, RBI can suck out excess rupee to ward off a liquidity overhang in the system. The liquidity corridor works through the repo and reverse repo route. The same mechanism can be extended for dollar liquidity. However, the central bank has reservations about this and has written to the Foreign Exchange Dealers Association of India (Fedai) that this in not in tune with international best practice.

The second step could be directing exporters to stop selling forwards for the time being. This may be interpreted as a retrograde step. But in the past the RBI had forced exporters to bring back exports proceeds in a hurry to pump more dollars into the system when there was a shortage. When we don't need dollars, RBI can as well tell exporters to wait and watch. Similarly, it can also put temporary restrictions on exporters' cancellations and rebooking of forwards contracts. In the past, the RBI has done so for importers. The RBI can also made it mandatory for corporations to hedge their foreign currency exposure. This will pep up the demand for the forward dollar. Another way of increasing supplies in the cash dollar market could be raising the banks' overseas borrowing limit. At present, it is capped at 25 per cent of the unimpaired tier I capital (that is, capital and free reserves) or $ 10 million, whichever is higher. If that is done, fears over a cash dollar shortage will recede and sanity will return to the market.

It can also pump in cash dollars by entering sell-buy swaps to meet the demand for dollars in the cash market. This essentially means the RBI will sell spot dollars and buy forwards. This way, it can pump in dollars to meet present demands and buy at a future date to balance forwards selling by other players. Finally, it can allow the rupee to appreciate without any intervention. This route will put an end to the expectations game. But exporters may feel that there is a limit to which the rupee can appreciate and once it reaches that level, the trend has to be reversed. They may wait to sell forwards at that juncture.

If the anomaly in the forward markets is not corrected, the RBI will not be able to check the flow of hot money into the system. It has already brought down the interest rates on FCNR(B) and NRE accounts to ward off the interest rate arbitrage opportunity. But when the forwards premiums are traded at a discount, foreign institutional investors and non-resident Indians get to earn a risk-free income in India on hot money. That is why the RBI is left with no choice: it must address the structural issues in the forwards market if it wants to shut the door on hot money.
Source: Business Standrad

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